Privately held companies can be valued by peer-group comparisons with similar stock-exchange listed firms and through cash-flow analysis.
Such companies differ from public limited companies (PLCs) and other stock-exchange listed firms. They do not have quoted share prices or need to report financial results to investors.
Family-owned businesses sometimes shun the capital-raising opportunities presented by initial public offerings (IPOs). They may instead want to keep tight, long‐term control over the business and avoid the pressures of contending with institutional shareholders.
But, with no share price for us to look up, how do we go about valuing private companies?
Comparable company analysis
Perhaps the most straightforward approach to valuing private companies is the so‐called comparable company analysis technique. Valuation is based on a comparison with public listed companies that have similar characteristics or with companies recently acquired for which relevant data is available.
To make a viable comparison in this way, we require at least some financial information on the private company.
Having established the value of comparable companies – companies of similar size in the same industry – we can calculate average peer‐group multiples. This can use variables such as earnings, sales and cash flow.
For instance, if we have an estimate for the annual sales of a private company, we can use the peer‐group price‐to‐sales ratio to reach a valuation estimate.
As an example, this latter ratio would be calculated by dividing the peer group’s market capitalisation by their sales in the most recent year. We can also adjust the multiple used for our private company according to parameters such as growth and risk.
Along with comparing the privately held firm to similar public listed companies, we can measure value against similar privately held businesses that have been recently acquired. Such transactions often throw up a treasure trove of information that would otherwise be unavailable.
Cash‐flow analysis tends to play an important role in private business valuation, as it does in the valuation of public listed companies. The expected future cash flows of private businesses available to equity and debt holders can be used to calculate the enterprise value (EV).
Cash flows are discounted using a rate that reflects the time value of money (cash flows received in the future are worth less than they are today).
The rate used should also reflect the individual business’s risk, with this a function of both the company’s cost of equity and debt.
However, as we normally do not have access to a private company’s financial statements, the EV we obtain for the private company should typically be considered as an approximate range estimate. This is because the inputs for the calculation depend on what we can obtain through our own research.
The cash‐flow projections for the private company valuation rely on future sales growth and operating profitability estimates.
At the same time, they also rest on assumptions surrounding depreciation (allocating the cost of tangible assets over their useful life) and working capital (a gauge of a firm's ability to cover its short-term obligations).
Once we’ve estimated EV for our private company, it’s common place to apply additional discounts. For instance, a minority control discount (where one party owns less than 50% of the firm) is typically applied, as partial ownership can be valued at less than its actual share of the business.
This is because majority owners in a privately held business hold the whip hand, potentially leaving those with a minority interest with little control over critical areas of decision-making.
Other discounts commonly applied to private company valuations include ‘lack of marketability’. This discount relates to the inherent lack of liquidity in owning an interest in a privately held firm versus being a shareholder in a public listed company.
Being unable to quickly sell an interest in a private company implies increased risk compared with owning shares in a quoted company. This is because economic and trading conditions can change dramatically over time and you may not be able to sell your stake.
Valuing privately held firms is typically more subject to estimation compared with valuing publicly quoted companies. The results we derive in private company valuation depend in large measure on the success of our research in piecing together a financial picture of the underlying business.
Valuing public listed companies is therefore much more straightforward, in that we have reams of information at our disposable. They are compelled to furnish their shareholders with detailed, regular financial statements.
At the same time, public listed companies provide many clues to valuing their privately held counterparts when the businesses are truly comparable.
In addition, the prices paid by the acquirers of private companies with similar characteristics, and the related financial information disclosed at such times can enable us to better value other privately held firms.