Private Equity Valuation

Summary

Private Equity Valuation

Difference Between Public and Private Company

Stage of Business Lifecycle: Private companies are generally less mature compared to their publicly traded counterparts. However, it's worth noting that there are instances where private firms exhibit maturity or are on the verge of bankruptcy and liquidation. The approach to valuation analysis varies depending on the stage of a firm's lifecycle.

Company Size: Private enterprises typically possess lower capital, fewer assets, and a smaller workforce in comparison to public corporations. Consequently, private firms can carry a higher level of risk. This often results in private firms being evaluated with more significant risk premiums and higher required returns relative to their public counterparts. The absence of access to public equity markets can limit the growth potential of private companies. Nevertheless, the regulatory complexities associated with issuing public equity may outweigh the advantages of increased funding opportunities.

Management Competency and Depth: Smaller private companies may encounter challenges in attracting as many qualified candidates as public firms. This limitation can reduce the depth of management, hinder growth, and elevate risk for private enterprises.

Management and Shareholder Alignment: In most private companies, the management team holds a significant ownership stake. In such cases, external shareholders exert less influence, allowing the company to adopt a longer-term perspective.

Short-Term Focus: While compensation packages for managers in public companies often include incentives like stock options, shareholders frequently emphasize short-term performance metrics such as quarterly earnings levels and consistency. In contrast, private firms, where managers typically hold substantial equity interests for the long term, may adopt a more extended time horizon.

Quality of Financial and Information Disclosure: Public corporations are obligated to provide comprehensive, timely financial disclosures. In contrast, potential creditors or equity investors in private firms have access to less information compared to public entities. This information gap results in increased uncertainty, higher risk, and lower valuations for private firms. It's important to note that in the context of fairness opinions for private firm valuations, analysts typically have full access to the firm's financial statements and business records.

Tax Considerations: Private companies often place a higher emphasis on tax planning compared to public firms due to the significant impact of taxes on private equity owners and management.

Three major approaches to private company valuation

1. Income Approach to Valuation: The income approach values a company by calculating the present value of its expected future income. This approach assumes that the value of a business is primarily determined by the cash flows it is expected to generate in the future. To apply this approach, you typically use methods such as the discounted cash flow (DCF) analysis. In DCF, you estimate the future cash flows a business is expected to generate and then discount them back to their present value using an appropriate discount rate. This approach is often used for companies with stable and predictable cash flows.

2. Market Approach to Valuation: The market approach values a company by comparing it to similar companies or recent transactions in the market. This approach relies on the principle that the market provides the most accurate reflection of a company's value. In this approach, you look at key financial metrics and multiples of comparable companies (often referred to as "comps") or recent sales of similar businesses. Common multiples used in the market approach include price-to-earnings (P/E), price-to-sales (P/S), and price-to-book (P/B) ratios. This approach is particularly useful when there is a strong and active market for similar businesses.

3. Asset-Based Approach: The asset-based approach values a company by calculating the net value of its assets after subtracting its liabilities. This approach is based on the premise that the value of a business is primarily determined by the value of its underlying assets.

Types of Market Based Approach 

1.Guideline Public Company Method (GPCM):

• Utilizes price multiples from trade data of public companies.
• Requires adjustments to the multiples to account for differences between the subject private firm and the comparable public companies.
• Ensures the comparability of the data used.

Control Premium Estimation:

• Necessary when evaluating a controlling equity interest in a private firm.
• Represents the additional value associated with having control over the company compared to a noncontrolling interest.
• Calculated as the difference between the pro rata value of a controlling interest and the pro rata value of a noncontrolling interest.
• Most public share trades involve small, noncontrolling interests, so they do not inherently include a control premium.

Estimating Control Premium:

• Look for public company transactions where an entire firm was acquired.
• In such transactions, the buyer acquires a controlling interest, and the purchase price reflects the value of control.
• Analyze these acquisition transactions to estimate the control premium.
• A complex process that considers various factors and industry-specific variables.
• The control premium can vary significantly based on the circumstances of the acquisition.

In summary:

• GPCM uses public company price multiples, adjusted for comparability.
• Control premium estimation is crucial when valuing a controlling equity interest in a private firm.
• Control premium reflects the extra value of control, typically not included in public share trades.
• Estimating the control premium involves analyzing acquisition transactions for entire firms.

2.Guideline Transactions Method (GTM):

• Utilizes historical acquisition values of entire companies, including both public and private entities.
• No additional adjustments for controlling interest are needed since control premiums are already reflected in the acquisition values.
• Focuses on analyzing past transactions to estimate the value of a subject company.

Considerations when Using Multiples from Historical Transactions:

• Data Availability: Private firm transaction data can be limited and less accessible.
• Data Accuracy: Verification of accuracy in private company transaction data can be challenging.
• Comparability: Ensuring comparability with the subject company regarding industry, size, and other factors is crucial.
• Timing: The timing of historical transactions and changing market conditions can affect their relevance.
• Deal Structure: Differences in terms and structures of historical transactions should be considered.
• Synergies and Special Situations: Unique factors like strategic synergies may impact historical transaction values.

3.Prior Transaction Method (PTM):

• Utilizes transaction data from the stock of the subject company itself.
• Most suitable for valuing minority (noncontrolling) interests in the company.
• Valuation can be based on either the actual transaction price or multiples derived from these transactions.

Risk associate with Investing in Private company

Liquidity:

• Private company equity is typically less liquid compared to publicly traded equity.
• The restricted market for private shares means fewer potential buyers, making them less easily tradable.
• In private company valuation, a liquidity discount is commonly applied to account for this reduced liquidity.

Restrictions on Marketability:

• Private companies often have agreements or restrictions in place that limit shareholders from selling their shares freely.
• These restrictions can significantly reduce the marketability of shares, as shareholders may be unable to sell their holdings at will.
• These limitations on marketability should be considered when valuing private company shares.

Concentration of Control:

• Private firms usually have a concentrated control structure, with control held by a few key shareholders or managers.
• This concentration of control can lead to the granting of greater perquisites and benefits to those in control.
• Such benefits may come at the expense of minority shareholders, impacting the overall value of the company.