Private Equity

General Valuation Issues for Private Equity

Public limited company’s shares are traded on regulated stock exchanges and therefore, are easier to value when compared with the valuation of private companies because private company’s shares are purchased by buyers each having a different valuation method for the same company. Furthermore, PE firms often transform and reengineer the portfolio company such that future cash flow estimates are difficult to obtain.

The following methods are normally used to value a private company.

  1. Discounted cash flow (DCF) analysis

DCF is a valuation method that estimates the value of an investment on the basis of future cash flows. DCF analysis basically figures out the value of an investment that is in today\’s terms, based on projections of how much money it will generate in the future.

It is most suitable for valuing companies that have a substantial operating history because this method, as expressed by the name requires an estimate of cash flows.

  1. Market or relative value approach

A relative valuation method compares a company\’s value with that of its competitors or industry in order to assess the firm\’s financial worth.

Mainly, this method uses a price multiple, such as the P/E ratio (Price Earning ratio), to get an estimate of the company’s value. This method requires expected cash flows and significant operating history.

  1. Real option analysis

The real option is modern technology as to how to make decisions regarding investments when the future is not certain. This method draws parallels between the valuation of the financial options available and the real economy.

It is suitable for growing companies that have flexibility in their future strategies.

  1. Replacement cost

Replacement cost refers to the sum of money which a business must currently spend to replace an important asset.

It is generally suitable for companies whose historical value is hard to estimate.

  1. Venture capital method:

VC Method is comprised of six steps: Estimate the Investment Needed, Forecast Startup Financials

Determine the Timing of Exit (IPO, M&A, etc.), Calculate Multiple at Exit (based on comps), Discount to PV at the Desired Rate of Return and Determine Valuation and Desired Ownership Stake

VC may decide to redeem the investment within 3 to 7 years. Their primary focus is to earn capital gains. Venture capital may not be suitable for an entrepreneur whose business plan will take a longer time to provide liquidity.

  1. Leveraged buyout method (LBO):

A leveraged buyout (LBO) valuation method is a type of analysis used for valuation purposes. The alternative sources of funds are analyzed in terms of their contribution to the net IRR. This analysis is carried out in order to protect the enterprise value of a company by the financial buyer that acquires it. When a company is purchased with significant amounts of borrowed money, keeping its assets as collateral and using its cash flows can be a way to service the debt.

If the company\’s cash flow and the sale of assets are insufficient to meet the interest payments arising from its high levels of debt, the LBO is likely to fail and the company may go bankrupt. Attempting an LBO can be particularly dangerous for companies that are vulnerable to industry competition or volatility in the overall economy.

Other techniques for valuing a private company are control premium, country risk, and marketability, and illiquidity discounts. In buyouts, the private investors normally have full control over the entity. However, in venture capital investments investors have less control and a minority position. When valuing private companies in developing business markets, the country risk might be added, subsequently increasing the discount rate that is applied to the /organization\’s cash flows. Illiquidity and marketability discounts refer to the ability and right to sell the company’s shares, respectively.

To value privately-owned companies, many investors use market data from similar publicly traded companies, most commonly the price multiples from comparable public companies. However, it is often difficult to find public companies at the same stage of development, the same line of business, the same capital structure, and the same risk. A decision must also be made as to whether trailing or future earnings are used. For these reasons, a relative

value or market approach should be used carefully.

Market data is also used with discounted cash flow (DCF) analysis, with beta and the cost of capital estimated from public companies while adjusting for differences in operating and financial leverage between the private and public comparable. In DCF analysis, an assumption must be made regarding the company’s future value. Typically, a terminal value (i.e., an exit value) is calculated using a price multiple of the company’s EBITDA

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