VALUATION OF A PRIVATE COMPANY

Let us first differentiate a Private Company from a Public Company. A Private company is a company owned and controlled by a private individual, and the numbers of shareholders are relatively small. The shares of a privately held company are not traded on the public stock exchange, but can be sold to a few willing investors. While a public company is a company owned and controlled by the government (Public). The securities of a public company is traded on the public stock exchange.

Alright, let us explain the term ‘Valuation of a Private Company’. In a simple language, Valuation of a private company is a set of procedures carried out to determine the current net worth of a particular private company. “Valuation is a process used to determine what a business is worth. Determining a private company’s worth and knowing what drives its value is a prerequisite for deciding on the appropriate price to pay or receive in an acquisition, merger transaction, corporate restructuring, sale of securities, and other taxable events. Private companies may include small family-owned enterprises, divisions/subsidiaries of larger private companies, or large corporations”.http://www.privco.com/knowledge-bank/private-company-valuation/ Although, the shares of private companies are not typically accessible to the public, there are times when one may need to raise capital, as a result, need to sell part of the ownership in the company. For instance, a private company may wish to offer employees, or to any investor the opportunity to be part of the owners of the company by purchasing stock in the company. Also, a privately-held company may require capital from private equity investments and venture capital. In this case, those investing in a private company must be able to evaluate the company’s current net worth before taking a step for investment decision. In the next section, we will be discussing some of the methods of valuation of a company investors can use. Many of the methods used in valuation of public companies can also be used in valuation of private companies as well. However, finding a suitable is a difficulty and tricky task. It encompasses a set of calculations and assumptions based on company specific and industry-wide statistics. Valuation of a private business includes key planning, adjustments on financial statements and also applying the best suitable valuation methodology. One has to be aware of the various factors that influence the valuation of a private company. The factors include: size, management and operational control, earnings and cash flows, capital structure, risk in the business, etc.

 

METHODS OF VALUING A PRIVATE COMPANY

Some of the methods used in valuation of a private company’s current net worth are:

• Discounted Cash Flow (DCF) Analysis,
• Break-up Analysis
• Asset Valuation
• Comparable Company Analysis

 

Let us have a discussion on each of the methods

 

DISCOUNTED CASH FLOW (DCF) ANALYSIS:

Discounted cash flow analysis is an analytical tool used in calculating the present value of an investment’s future cash flows in order to arrive at a current fair value for the investment. Using Discounted Cash Flow as a method of valuation of a private company, firstly, one has to compute discounted cash flow of similar companies in a peer group and then compare with the computed discounted cash flow of the target private company to be invested on.

Steps to be taken:

There are different stages in valuing a private company with DCF method. In the first stage, scenarios are generated to know what the future free cash flows would be like in the next 5-10 years. Moving to the second stage, an appropriate discount rate, weighted average cost of capital (WACC) have to be known in order to discount all future Free Cash Flow and calculate their Net Present Values (NPVs). In the third stage, we need to consider the terminal value (TV). The terminal value (TV) is the result of net present value of all future cash flows that accrue after the time period that is covered by the scenario analysis. In the fourth stage, the net present values of the cash flows are summed up with the terminal value.

Calculation of free cash flow:

Calculating the free cash flow of the target private company, we then make projections for the company’s operating costs, taxes, and working capital. From the estimations, free cash flow for the target private company is generated. Free cash flow is used by investors to determine how much money is available in the company to give out to its shareholders. Formula for free cash flow = EBIT (1-Tax rate) + (Depreciation + Amortization) – change in net working capital) – (capital expenditure).

Calculation of the weighted average cost of capital:

Weighted Average Cost of Capital is the rate used to discount the Free Cash Flow (FCF). The WACC rate a very important factor in the DCF model. Any change in the WACC will definitely cause large changes in the value of a company. To calculate the WACC, we need to weight all the sources of finance according to the company’s financial structure then multiple them with their costs. Formula for WACC is:

Calculating Cost of Equity:

The target private company’s cost of equity can be calculated by using the Capital Asset Pricing Model (CAPM). The CAPM helps one to know the return that investors require for bearing the risk of holding a company’s share.

Cost of Debt (COD):

The cost of debt (COD) is the interest rate a company has to pay on their outstanding debt. The company’s debt rating is a factor one has to consider. For instance, a private company that has an investment grade credit rating AAA is able to borrow at lower interest rates than a company that is rated as non-investment grade of BB.

The difference between the risk-free interest rate and the interest rate. For the true COD to be lower than the interest rate a company pays out to its debt holders, tax is deducted from the interest rate costs.

 

Formula for COD = 𝑖 ∗ (1 − 𝑡)

Where: 𝑖=interest rate on outstanding debt

T=tax rate paid by the company.

Limitations of Discount Cash Flow Limitations as a method of valuation of private company

Discount cash flow is a powerful tool that one can use in valuation of a private company, but also have some limitations. One limitation is the difficulty of estimating cash flows and trustworthy discount rate in a private company; DCF method sometimes assume that a company will be in operation for a long period of time, this is not so. A slight change in the company’s cash flow growth rates or discount rate can cause a big reduction in value.

 

BREAK-UP ANALYSIS:

Breakup analysis is used in determining the worth of a company if it is sold in segments. A Break-up Analysis is used when a company is engaged in different lines of businesses. The analysis sums parts valuation based on different business lines, the value of each part is computed separately and then summed together. If the breakup value of a private company is greater than its current market value as a single company, it can make more sense to the shareholders to sell off pieces of the firm in order to increase the realized value.

The best way we can explain this method is with the help of an illustration. Let us use a company called Matog Limited. The table below shows the valuation of Matog Limited that has 3 business segments (Books selling, Business Advisory and Car accessories)

 

The illustration above shows that the company’s equity between ₦53,000,000 and ₦59,000,000, or between 13.25 and 14.75 Naira per share.

Limitations of using Break-up Analysis:

Breakup analysis does not take in consideration tax implications. Using the illustration above, this shows that other values of the company are not taken into consideration, values like, goodwill, patent right, trade mark etc.

 

ASSET VALUATION:

An asset is a resource (whether tangible or intangible) owned and controlled by a company, arising from a past event, which the future economic benefit from it flows into the company. In asset valuation method, the business of the private company is estimated as being worth the value of its net assets.

There are three (3) main ways of valuing the company’s net assets: Book values, Net realizable values, and replacement values.

• The book value approach: this approach is based on the historical costs of the asset. This approach is unlikely to be relevant to purchasers (investors) because, the inventories and receivables might require some adjustments.
• Net realizable values: this approach represents what should be left for the shareholders if the assets were sold off and liabilities settled.
• Replacement values: this method tries to determine what it would cost to set up a company if it was being started newly.

Of the three approaches above, the best approach is the net realizable value because it represents the sellers with the lowest value they should accept.

To understand this very well, let us look at an illustration. Below is a table of Matog Limited Statement of financial position (Balance sheet) as at the year ended 31 December, 2018:

Matog Limited non-current assets contain land and buildings that are valued $700,000 above their historical value (book value), and plant and machinery, which would sell for $200,000 less than their historical value (book value). Closure costs would add $100,000 to liabilities.

 

₦1,550,000, (or ₦2,550,000 – ₦400,000 – ₦600,000) is the minimum amount that the shareholders should accept for matog limited.

 

 

 

Limitation of Asset Valuation:

Valuing a private company with asset valuation method does not consider other intangible assets like Goodwill, trade mark, Patent right, etc. that the company may have. In the case of Matog Limited, if all these assets are computed and their values are estimated, the company’s value or worth (₦1,550,000) might be higher than what it is now.

 

COMPARABLE COMPANY ANALYSIS:

Comparable company analysis is a valuation methodology that examines the ratios of public companies in terms of similarities like size, characteristics, nature of the business etc. to derive the value of a target company (private company). This analysis involves searching for publicly traded companies that are most closely related to the private company (target company) in terms of competition, size, age, and growth rate to determine the value of the private company (target company).

Steps in comparable company analysis are:

• Compile and select the list of comparable companies (publicly traded companies)

In selecting the comparable companies, one has to understand the private company’s business to ensure that its comparable companies share similar industry, financial characteristics, and business with the private company (target company). Do not forget to gather relevant financial information from the comparable companies.

• Calculate relevant financials and multiples

After selecting a group of comparable companies, a list of ratios and values to compare are generated. These include price, earnings per share (EPS), shares outstanding, growth rate, price-to-sales ratio (P/S), price-to-earnings ratio, enterprise value (EV), earnings before interest, taxes, depreciation and amortization (EBITDA), etc. After gathering information concerning the above listed, calculate multiples. Comparable analysis can be done using trading multiples (i.e. how the company operates) or transaction multiples (i.e. at what relatively level was the company bought or sold) on precedent transactions.

Some of the multiples used are: Pricing to Earnings; Return on Capital Employed; Enterprise Value/ EBITDA; Return on Assets; Price to Book Value.

• Evaluate and analyze the results

After computing the relevant multiples, one has to determine valuation ranges. To compare the private company with the comparable group of companies effectively, you must have an understanding of why their multiples are different. Some of the reasons why one private company’s Enterprise Value (EV) or Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) multiple maybe lower than that of a comparable group companies include slower projected growth, declining margins, etc.

CONCLUSION

The question of “how do you value a private company?” is a simple question that has a complex answer. Not all the valuation methodologies discussed above would be appropriate in all situations.

Among the methods discussed above for valuation of a private company; Discount Cash Flow (DCF) analysis, Break-up analysis, and Asset Valuation are less likely options because they require detailed financial information from the private company. Because private companies manage their balance sheet and earnings for different purpose and goals than public companies, using Comparable Company Analysis or Discounted Cash Flow analysis for valuation of private company require additional insight. Because of lack of liquidity and increased risk in business, the discount rates used in Discounted Cash Flow analysis needs a modification. Therefore a more likely and suitable approach is to find companies that are comparable and whose values are known.

Each valuation method has its own particular purpose and should be used in that respect. Also, one has to note that one analysis by itself might not yield a pinpoint result that can be relied upon. Rather, it is feasible that one will need to adopt multiple valuation methods to arrive at a range of values for private company. Each valuation method provides an additional clarity on the other valuation methods. Using numerous methods of valuation of a private company provides a better understanding of the company’s worth.

 

 Author: Noel Agwulonu

 

REFERENCES

Florian, S. (Seminar Paper Fall 2008). The Validity of Company Valuation Using Discounted Cash Flow Methods. Retrieved from https://arxiv.org/ftp/arxiv/papers/1003/1003.4881.pdf (accessed on 30-May-19).

 

Business Valuations: (2014, March 20). Retrieved from https://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_feb12_f9_valuationsv2.pdf (accessed on 30-May-2019)

 

Asset Valuation: (Updated Apr 30, 2019). https://www.investopedia.com/terms/a/assetvaluation.asp(accessed on 30-May-2019.