Valuation of a private company, partnership or proprietary follows a set of procedures used to evaluate the net worth of a company. For various public domain companies, the system is entirely different. We can retrieve the company’s stock price and the outstanding shares from various databases such as Bloomberg or Google Finance.
On the contrary, private companies’ procedure is entirely different. Companies don’t publically list information regarding their stock value. Privately held firms don’t operate according to the accounting and reporting standards that govern public organizations. And therefore, all their specific financial statements may not be consistent and are not standardized. This makes it more difficult to interpret the data.
Let us understand how to do valuation a private company.
The two most common methods for valuation of a private company
1. Comparable Company Analysis Methodology
Assumption: All similar firms in similar industries have the same multiples.
Let’s understand some basic financial terms used in the blog?
When the financial information of the private company is not publicly available in their footnotes or statements, search for companies that are similar to our target. And then determine the valuation of the private company using the comparable firms’ multiples method.
First: Identify the target firm’s characteristics in size, resources, industry, operation, capital, etc., and form a genuine pool of companies that share similar characteristics.
Second: Collect the multiples of these companies to calculate the industry average. The choices of multiples can depend on the industry and growth stage of firms. We use EBITDA multiple most commonly and below shown is an example of valuation
EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization
Enterprise Value: It is the Levered value of a company, i.e Equity Value-added wit the market value of debt of the company.
The firm’s valuation formula is expressed as follows:
Value of target firm = Multiple x EBITDA
Where, Multiple (M) is the average of Enterprise Value/EBITDA of all our pooled comparable firms, and the EBITDA of the target firm is normally projected for the next twelve months.
2. DCF (Discounted Cash Flow) Methodology
Discounted cash flow (DCF) analysis is a method of valuing intrinsic value(IV) of a company (or an asset). It tries to work out the present value, based on projections of all of the cash that it could make available to investors in the future.
DCF is said so because of the principle of the time value of money. (cash in the future is worth lesser than the present cash in hand due to external factors).
What are the advantages of DCF?
It produces the closest thing to intrinsic stock value.
Relative valuation metrics such as price-earnings (P/E) or EV/EBITDA ratios aren’t useful if an entire sector, industry or market is overvalued or under-valuated. Also, the DCF method is forward-looking and depends more on future expectations than past historical results.
The method is also based on free cash flow methodology (FCF). It is less subject to manipulation than other figures and ratios calculated out of the income statement or balance sheet. And therefore it is a good method for the valuation of a private company.
How does the method work?
- Estimate Cash flows
- Estimate Growth Profile (1 stage, 2 stages, 3 stages, etc.) & Growth Rates
- Calculate the Discount Rate, Terminal Value, the fair value of a company and its equity beta
- Estimating Cash flows
A: Estimating Cash Flows using Free Cash Flow to the Firm (FCFF)
This is equivalent to the cash available to bondholders and stockholders resultant after all expenses and investments have already taken place.
B: Forecasting the Cash Flows growth profile
The next part is to estimate how fast will the company grows its free cash flow. This is a very important part of any valuation and is typically where the biggest errors creep in. People tend to overestimate how fast a company can grow.
1. Extrapolate from historic growth
One option is to use historic growth rates and forecast further.
2. Trust on the financial Analysts
The second approach is to trust the equity research analysts that follow the firm to come up with the right estimate of growth of the firm. And to use the same growth rate in the valuation procedure.
FCF = EBIT(1-t) + Dep & Amort – Capital Expenditure – Net increase in working capital
For an all-equity firm, what are the other relevant cash flows?
3. Fundamental Determinants
With both historical and analyst estimates, growth is treated as an exogenous variable for valuation. It affects value but is divorced from the operating details of the private company. The other way of incorporating growth into the intrinsic value is to make it endogenous, i.e., make a firm reinvest for future growth and the quality of its reinvestment.
4. For a firm with stable return on capital, its expected growth in operating income (and therefore the resulting cash flow) is a product of the reinvestment rate
The return on the capital invested by the firm is the proportion of after-tax operating income. We invest it in net capital expenditures and non-cash working capital, and the quality of reinvestments.
Looking at historic growth over the past several years, and taking an average, and then reducing that in stages. The three-stage model might take the last 3-years’ growth rate, applying it to the next five years, then chop it in half for the next five years, reducing it to 3% (the long-term rate of inflation, e.g. no “real” growth) from then on.
C: How do we choose a discount rate and calculate the net present value?
To find the valuation of a private company and project the company’s free cash flow (FCF) for the coming X years, we must have an appropriate discount rate which will, in turn, be used to calculate the net present value (NPV) of the cash flows. This is critical in discounted cashflow valuation.
Errors in estimating the appropriate discount rate or mismatching of the cash flows and discount rates can lead to serious mismatches in valuation resulting in overvaluation or undervaluation. The Discount Rate we suggest must be consistent with the cash flow that will be discounted for.
If the cash flows that are being discounted are cash flows to equity, the appropriate discount rate is the cost of equity.
If the cash flows discounted are cash flows to the firm, the appropriate discount rate is the cost of capital (or WACC – the weighted average cost of capital).
1. Cost of Equity
Equity shareholders expect to obtain a certain return on their equity (RoE) investment in a company. From the company’s perspective, the equity holders’ required rate of return (RRR) is a cost. The cost of debt is relatively easier to obtain from observation of interest rates in the equity or debt capital markets. But the company’s current cost of equity is unobservable and must be estimated uniquely.
There are several ways of calculating discount rates.
Let’s look at the most popular methods of discounted cash flow (DCF) analysis:
WACC (Weighted Average Cost of Capital)
For WACC, we need to calculate the discount rate for leveraged equity (reL) using the capital asset pricing model (CAPM).
For WACC, the discount rate is calculated using the following formula:
D = Market value of debt
E = Market value of equity
rd = Discount rate for the debt of the firm
The discount rate for (levered) equity (it is calculated using the CAPM)
2. Capital Asset Pricing Model (CAPM)
To find the appropriate discount rate used for discounting the company’s cash flows, we use the Capital Asset Pricing Model (CAPM). This model is used to calculate the expected return on your investment, also referred to as the expected return on equity (RoE).
This is a linear model with an independent variable, Beta. Beta represents the relative volatility of the given investment concerning the market. Beta is also known as a measure of systematic risk.
If the Beta of an investment is I, the returns on the investment (stock/bond/portfolio) vary identically with the market returns. A Beta less than 1 suggests that the investment is less volatile than the market scenario.
A Beta of greater than 1, suggests that investment is more volatile than the market scenario. We expect a company in a volatile industry to have a Beta greater than 1. A private company whose valuation does not fluctuate much, eg: an electric utility, will have Beta under 1.
Note: Beta of the market is always equal to 1.
Mathematically, we can calculate CAPM as:
re = Discount rate for an all-equity firm
rf = Risk-free rate (we consider Treasury bill rate for the period the cash projections. For example, if we are taking into consideration 10 years, then the risk-free rate (rF) is the rate for the 10-year U.S. Treasury note.)
rm- rf = Excess market return (This is the excess annual return of the stock markets over a U.S. Treasury bond for a long period. This is assumed to be 7% for the U.S. Market scenario.)
ß = Equity Beta
If you are finding the valuation of a private company that is not public, then you need to get a firm with a similar Balance Sheet and Income Statement that is public. (When calculating CAPM, we use the “equity Beta” value and not “assets Beta.”). If we have information for Beta assets rather than Beta equity, we can derive Beta equity using the relationship below.
D = Market value of debt (book value of debt)
E = Market value of equity (number of shares outstanding x share price)
ßd = Beta debt (assume this to be equal to 0)
t = Corporate taxes, (assumed to be 30- 35%)
3. Net Present Value
Consider an example. Let’s say we had an arrangement set to receive $20 from a friend one year from now. Now let’s say we decide that we don’t want to wait for a year and would have the money on the present day. How much should we be willing to accept at present? More than $20, $20, or less than $20?
A dollar’s worth in the present-day is more than a dollar tomorrow for two simple reasons.
First, we can invest a dollar today at a risk-free interest rate and can earn a return. A dollar tomorrow is worthless because it misses out on the interest that we can earn if we invest it today. Second, inflation diminishes the purchasing power of future capital.
A discount rate is a rate you choose to discount the future value of your money. A discount rate is the expected return from a project/product or service that matches the risk profile of the project in which we would invest your $20.
Note: The discount rate is different than the opportunity cost of the capital. Opportunity cost is a measure of the lost opportunity. The discount rate is the measure of risk. To express the relationship between the present value and future value, we use the formula as below:
Here, “Rd” is the discount rate and “n” is the number of years in the future of the forecast. The method of calculating the discount rate is different depending on the method of valuation used (i.e., NPV method vs. WACC method) for a private company. Though the discount rate varies, the concept of NPV (net present value) remains the same.
A series of cash flows is:
We calculate the Net present value (NPV) in Year 0 of future cash flows with the formula below:
rd is the discount rate, we calculate it differently depending on whether you use NPV or WACC.
Terminal Year Calculation
The year (usually 10 years in the future) when the growth of the company is stable, it is called the terminal year.
Company management or a financial analyst determines the cash flows for the first 10 years. It is based on predictions and forecasts of what will happen and an assessment of future investments.
We assume that after year 10 the cash flows of the company keep growing at a constant “g.” Values of “g” are typically not as high as the first 10 years of growth ( un-stabilized growth periods ). “g” represents the amount the company can feasibly grow till perpetuity once it has stabilized (after 10 years). Terminal year cash flow (the value in year 10) value is given below:
The present value of the terminal year cash flows is:
Adding the discounted value of the first 10-year FCFs, and the terminal year FCFs (CFs after year 10 into perpetuity). It gives the value of the company under the DCF analysis.
Given the following information for the company that we are valuing
Step 2: Cash flows
Step 3: Discount rates
Let’s understand the WACC method. For WACC, we need to know what the target (long-term) debt-to-capital ratio for this company is. Let’s assume that it is 40 percent as of date. In the long run, this company expects to finance its projects with 40 percent debt and 60 percent equity capital.
Note: We calculate our expected return on equity, or re, using the target debt-to-equity ratio. Since our long-term debt rate is 12%, and our long-term debt is 40%, we calculate WACC.
D: Terminal value
For this method of valuation of a company, we assume that the company operates forever: Going Concern Concept. But, we only have four years of cash flow. We need to forecast value on all cash flows after Year Four. The Year Four has a cash flow which is 4.16 and we expect it to grow at 5 percent a year. We find value after year your using Terminal value formula.
Using these cash flows, with a discount rate of 17.0 percent, we can calculate an NPV
(r = r WACC)
E: Figuring out the company’s value
The value of the company is approximately $31.0 EVA. Deduct the cost of capital from operating profit (adjusted for taxes on a cash basis) to measure the company’s financial performance based on residual wealth. (“economic profit”.)
The formula for calculating EVA is as follows:
EVA= Net Operating Profit After Taxes (NOPAT) – (Capital * Cost of Capital)
We use assumptions and estimations for the valuation of a private company. Taking the industry average based on multiples and growth rates provides a guess for the true value of the target firm. It cannot account for extreme events that affected the comparable public firm’s value at that moment. We need to adjust for a more reliable and precise rate, excluding the effects of such rare events.
Also, the recent transactions in the industry such as acquisitions, mergers, or IPOs provide financial information. It gives a far more optimized estimate of the target firm’s worth.
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