Saturday, April 17, 2010

To Buy or To Sell? Techniques in the Valuation of Private Companies

Valuation of private companies is a challenging task. Financial data on private companies is not usually available while the market for private transactions is less liquid than this of publicly traded companies. Yet, it is often imperative to assign a specific value on a private business. This could be part of due diligence before and during a transaction or a necessary internal process for allocation of shares among owners or employees.

Quantitative data must be used in combination with contextual and subjective information on the company. There is no absolute value to be derived with calculations and no mathematical formula that can be used with exact science. Additionally, even when one has been hired internally to conduct research and value the company, which consequently means that one has access to all in-house financial data, the market plays a major role in the final valuation. This has to do with market liquidity at that particular time but also with recent sales transactions of comparable companies. Price-earnings relationships defined in other sales can be applied to value the company.

When I am asked to value a company I prefer a combination of discounted cash flow techniques (DCF) and price-earnings multiples from comparables. Generally, I tend to mistrust appraisers’ approach that is based on industry-specific formulas, which account for financial and operational data and result in an approximate figure. Given that figure, I would still run a DCF valuation because it calculates the underlying economic value of the company based on the company’s ability to generate cash in the future. This method presents inherent difficulties such as forecasting expected cash flows and estimating the cost of capital to be used as the discount rate in the calculations.

Multiplies are based on revenue and earnings figures found on the income statement or on assets found on the balance sheet. For example, one may want to look at Price/Revenues (P/R), Price/EBIT (Earnings Before Interest and Taxes), Price/EBITDA (Earning Before Interest, Taxes, Depreciation and Amortization), Price/Earnings (Net Income, after all expenses and taxes). A valuation based on these numbers may result in a value that needs adjustment up or down by as much as 30%. This often has to do with the size of the company and the premium that is assigned to large companies (larger companies are worth more than small companies in general) or the discount rate applied to private companies to account for the lack of liquidity within the market. Furthermore, a premium may be assigned for substantial assets on the balance sheet, or excess cash, or a superior brand etc. The company is always worth more to a strategic investor who gets involved in managing the business and therefore contributes with value added.

The complexities of a multiples-based valuation are numerous but may be clarified when a DCF approach is applied simultaneously. A DCF valuation usually consists of four steps: 1. Forecasting of future cash flows for five years and for a best and worst case projection; 2. Estimating the firm’s value at the end of the forecasted period (residual value); 3. Estimating the cost of capital using the weighted average cost of capital (WACC) formula; 4. Calculating a net present value (NPV) of the firm by discounting the residual value and each year’s cash flow projection by the appropriate discount rate and then adding them together.

It is important to value the company based on both approaches because while its market value is a reflection of the underlying economic value, if the numbers reveal inconsistencies (unusually low or high market value) this may point to a buying or selling opportunity.

1 comment:

  1. Very interesting!
    I was also wondering what you thought about the situation in Greece and the UE/IMF bailout package.