Private Company Valuation Methods and an Important Rule of Thumb

May 1, 2020

The situation in our world right now is changing quickly. Consumers, communities, and businesses of all sizes are experiencing significant economic and social impacts. Businesses are scrambling to address the crisis by making adjustments to their workforce, operations, supply chain, and strategy in an attempt to maintain continuity.

Right now, many private companies have had to make some tough decisions and are looking to sell or merge their businesses, quickly.

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Although the circumstances are not ideal, this is a good time for those with the capital to invest in private companies but they need to move quickly.

If you are looking to invest in private entities, you need to know the company’s economic value to determine if it is worth the time and effort.

Simply put, a company or business valuation is a set of processes used to determine a company’s net worth. This is easily done with public organizations because all you really need to do is look at the stock price.

Determining the valuation of a private company isn’t quite as straightforward because their stock value is not available to the public. Their accounting and reporting standards are also not as strict as their public counterparts so financial statements often are unstandardized or inconsistent.

For the reasons above, we have decided to put together this overview of private company valuation methods.

Method #1: Comparable Company Analysis (CCA)

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The Comparable Company Analysis (CCA) is the most common method used to estimate the value of a private firm and assumes that similar companies with more financial information available in the same industry will operate with similar multiples.

Multiples are measurement tools that evaluate one financial metric as a ratio of another in order to make companies easier to compare. The two main types of multiples are Equity Multiples and Enterprise Value Multiples. Enterprise Value Multiples are the most common multiples used in mergers and acquisitions.

Enterprise Value Multiples are also called EV/EBITDA ratios or EBITDA multiples. They compare the value of a company (including debt and other liabilities) to the actual cash earnings.

To apply this method, the target firm’s size, industry, supply chain, operations, etc. are taken into account.

You then need to establish a group of companies that have equivalent characteristics. The multiples of these companies are then collected to calculate an average.

This – and all of the methods on the list – do take some research and if you are new to private equity investments, it can get fairly involved. Analysis may uncover that a company is overvalued or undervalued when using this method.

Method #2: Discounted Cash Flow (DCF)

The Discounted Cash Flow (DCF) method estimates the value of a business based on future cash flows. DCF analysis finds the present value of future cash flow using a discount rate i.e. interest rate.

Investors use this concept to determine whether the projected outcome is equal to or greater than the value of the initial investment.

If the value calculated is higher than the current cost of the investment, this signals a good opportunity that should be considered because it will yield positive returns.

Applying the Method

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First, applicable revenue growth rate must be calculated for the target firm. This is calculated by determining the average growth rates of the comparable firms that are publicly traded.

Those averages are then used to generate projections for the target firm’s future cash flow (CF) by evaluating assumed revenue, operating expenses, taxes, etc.

The investor must also determine an appropriate discount rate (r), which will vary depending on the industry. Many analysts use the weighted average cost of capital (WACC) as the discount rate.

To find WACC for a comparable public firm, cost of equity, cost of debt, tax rate, and capital structure will all need to be determined. Cost of equity can be calculated by using the Capital Asset Pricing Model (CAPM). Cost of debt generally depends on the target firm’s credit profile, which will affect the interest rate at which it incurs debt. Refer to the company’s comparable public peers to find the industry norm of tax rate and capital structure.

After you have all of this information you can then determine the DCF of your target firm using the formula below:

DCF = CF1/(1+r)1 + CF2/(1+r)2 + CFn/(1+r)n

  • CF is the cash flow for the given year. CF1 is for year one, CF2 is for year two, CFn = additional years
  • r is the discount rate

If this seems complicated, that is because it is. If you don’t have significant experience in financial modeling, we suggest speaking with a professional.

It is important to note that this method is less common and that is because it is mainly based on assumptions and future cash flows would rely on a variety of factors that are difficult to predict and control like the state of the economy and market demand.

The Most Important Rule of Thumb in Private Equity Investing

Some try to say that there is a “secret formula” to determining if a private company is a good investment, but at the end of the day, you need to go with your gut. The numbers could look great but if you don’t think that the investment is right for you or your portfolio, we suggest looking into other opportunities.

At The DVS Group, we are well-versed in valuation analysis. We have helped many investors structure and negotiate their deals in a fair and reasonable way with our buyside representation services.

Learn More About Our Process

Risk Reward Ratio and Determining the Value of a Business

April 27, 2020

Understanding the risk-reward ratio is vital for anyone planning to acquire ownership of a business via private equity investment. When acquiring a business as an investment, there are some considerations that need to be assessed before deciding to proceed with the acquisition to ensure your money is protected and that the company you acquire is profitable.

What is a Risk-Reward Ratio?

Risk-reward ratios are used as a measurement of a business’s financial health and indicate whether or not it is a worthwhile investment and will be profitable in the long term.

Although risk-reward ratios are essential for risk management, merely understanding how the risk-reward ratio is calculated is not enough to make a smart investment. An understanding of the industry the company operates in is also needed, and its impact on the risk-reward ratio.

To make a sound decision, investors need to be fully aware of the level of the potential risk they are taking on when they are making a business acquisition. A thorough understanding of the company’s debt level and how that impacts on its potential profit and prospects for further reinvestment in the business needs to be understood.

How Risk-Reward Ratio is Calculated

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There are a few different risk-reward ratio methods used when assessing how good a private equity investment is likely to be. Different investors may have a preference over which method of calculation that they use. However, these are the most widely used methods for calculating an investment’s risk-reward ratio: debt to equity ratio, debt to capital ratio, interest coverage ratio, and the degree of combined leverage.

Risk-Reward Calculation Methods

Debt to equity ratio – Calculated through how much a company is financed through debt versus funds received by the business.

Debt to capital ratio – Calculated by taking a company’s debt and dividing it by the total capital.

Interest coverage ratio – Calculated by the number of times that a company can cover it’s annual interest payments for debt through its current earnings.

The degree of combined leverage – Calculates the financial and business risks of a company’s earnings per share as a result of increased or decreased sales.

Businesses with a lower debt to capital ratio and lower debt to equity ratio are the preferred choice for investors. Companies with higher debt to capital ratios and higher debt to equity ratios are seen as a less attractive investment opportunity as they offer little security or reassurance of a company’s long term profitability.

Risk-reward for private equity investments applies similar rules as those used in trading stocks and shares. Investors use the ratio to manage how much capital they are investing and manage the risk of loss. Using the ratio also helps investors to calculate how much return they can expect from the money they invest and will help to show how risky the investment is.

Determining the Value of a Business

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No one wants to spend more than they need to acquire a business. Therefore, calculating the value of a company is essential. It is crucial to remember that the value of a business will change over time, so finding a data-based, objective way to establish its value is ideal, rather than relying on the price that the seller wants to charge.

The value of a business is influenced by both internal and external factors, which means that the value can fluctuate by conditions both in the business’s control and those that it has no control over.

Internal factors such as investment in the future of the business and management changes can influence the value. External factors such as the economy or changes to the legislation can also impact value.

There are three main approaches used to calculate the value of a business: the asset approach, the income approach, and the market approach.

Asset approach – the asset approach calculates a company’s value based on its assets and liabilities. However, this approach overlooks assets that aren’t tangible and therefore, almost impossible to value things like patents, intellectual property, and reputation.

Income approach – the income approach to business valuation is based on a company’s cash flow minus the legitimate expenses that it incurs. Looking at a few years of the company’s cash flow information and taking an average will help you to estimate the business’s future earnings.

Market approachthe market approach is based on comparison and determines a business’s value based on data from companies operating in the same or related industries. This offers a reliable method of valuing a business as it is based on real-world examples of what a business is realistically worth.

Using the Market Approach to Evaluate Industry-Specific Investment Risks

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To gain a thorough understanding of a business’s potential profit versus its potential risk, it is essential to understand the industry in which it operates. This can be achieved by examining comparable companies operating in the same industry for guidance and utilizes the market approach to business valuation.

Investors that are considering the acquisition of a private company can refer to publicly traded companies in the same industry or that provide similar offerings and use this to evaluate the risk of their potential investment.

To ensure that the prospective investment will provide a worthwhile return, a risk-reward ratio can be seen in these similar businesses over the timeframe that you plan to hold onto the company before selling it to realize their return.

This information is extremely valuable in the decision-making process for business investments, as it takes objective data from the real world as the basis of the decision-making process.

Whether you’re an individual looking to acquire a business, the experts at DVS group can help you every step of the way. If you are ready to get started, call us at (913) 701-3475 or use the contact form to set up a consultation. You can also click below to view our Acquisition Workbooks and resources.

Check Out Our Acquisition Workbooks!

Opportunity Zones and Opportunity Funds

January 31, 2019

Thanks to Robert Drumm for writing this article for us. Robert is an attorney and entrepreneur with 16 years experience in special-purpose real estate finance and development, business transactions, workouts, and day-to-day business operations. He returned to full-time legal and consulting practice after successfully rejuvenating a specialty packaging business serving the craft beverage industry.

Starting in the 1920s, “1031 Exchanges” give real estate investors a way to recycle and preserve capital by deferring tax on gains from the sale of one property by promptly reinvesting it in another. Unfortunately, investors in operating companies have not had a similar vehicle to forestall the tax man. Read more

“Can I Afford to Buy a Business?” Two Frameworks to Help You Answer That Question

September 27, 2017

If you’ve ever considered purchasing a business, the thought right after, “I can be my own boss!” is likely “Can I even afford it?” Business ownership is rewarding in many ways- beyond finances. But it also brings lifestyle changes that impact those around you. It’s an investment you want to be confident in.

We won’t talk in absolutes about whether or not you can afford to buy a business. But, after a decade of seeing executives buy businesses, we’ve developed two frameworks that work in tandem for helping you answer that question.

Read more

Are You Ready to Buy a Business? Six Questions to Ask to Find Out

September 13, 2017

Are you ready to buy a business?

Below are six questions to help you find out.

These questions are tailored specifically for the individual executive seeking to acquire a business (a different set of questions should be asked by corporate buyers). If that’s you, take some time to consider these questions.

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70-90% of Strategic Acquisitions Fail – Here’s How Corporate Buyers Kill Deals

September 6, 2017

Strategic acquisitions have a historical failure rate of 70-90%. That’s a pretty dismal stat.

So, what are you doing wrong? And, more importantly, how do you properly lead your team in an acquisition process when the cards are stacked against you?

Below are five of the most common mistakes we see corporate buyers make when going through the acquisition process. These mistakes can be costly – especially, if the deal dies after you chased it for months. We’ve included reminders of basic, yet vitally important, acquisition principles that will allow you to steer clear of failure and action items to help your team gain momentum in the right direction.

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The Best Industry for Your Business Acquisition

June 7, 2017

“Which industry is best for
my business acquisition?”

Whether you are a corporate or individual buyer, one of your first questions in the process is likely that question.

Let me tell it to you straight – no industry is the best industry.
And I’m not just saying that so I don’t hurt any of the industries’ feelings.

You may have preferences and some industries may be better than others but, speaking from experience,
there is not a golden ticket industry that will take you to the chocolate factory of ideal businesses.

Read more

Buckle Up! 4 Ways Your Journey to Buy a Business Could Get Derailed

April 12, 2017

Are you properly settled in for the ride as a Blue-Chip Executive on the journey to buy a business?

The journey can be long and arduous, and you might get lost and never arrive, or crash on the way, or get distracted, or wind up at the wrong destination.

So, as you’re buckling your seatbelt, examine the ways your journey to buy a business could get derailed and then, take our tips to heart – they will help you stay on track.

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Letter of Intent: Crafting the First Step to a Successful Acquisition

March 1, 2017

You found the business you want to buy. Congrats!

Now what?

There are many things that need to happen before a deal closes. One of the first steps you’ll need to take is to write, sign and negotiate a Letter of Intent (LOI) with the seller. An LOI is a non-binding document, meaning there is not a legal requirement for things to play out exactly as the document states.

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Two Insider Tips for Picking a Bank for Your SBA Financing

February 1, 2017

SBA financing – particularly when used for business acquisition – involves very specific limitations and requirements. Because of its detailed and complex nature, using just any bank for SBA lending would be a mistake. Do your research and pick a bank that has experience and that you trust.

This is not an exhaustive shopping guide but these two tips will get you well on your way to making a solid choice in your SBA lender.

Read more

Don’t Fear the Acquisition Jump: How Nonprofits Acquire Private Businesses

December 20, 2016

As an executive at a nonprofit, you deeply and sincerely care for your organization’s mission. Fulfilling the mission is the pinnacle of your organization’s purpose. Whether that mission is employment services, environmental conservation or political advocacy, your mission is important and engaging to the community.

If you’re like other nonprofit executives, you consider your organization’s nonprofit status as an important piece of advocating for the mission. Carrying a 501(c)(3) status allows for distinct operations and means more money can go towards the mission. Therefore, you are understandably concerned about what acquiring a private entity could mean for that status.

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