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.
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)
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
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