Four Methods Of Private Company Valuation
The majority of M&A deals involve the purchase, sale, or merger with a privately held business. The challenge lies in how to accurately value these businesses. As we will see, there are four main ways that private companies are typically valued. We will look at these valuation methods, how they work, and look at some of the key challenges of private company valuation.
The Challenge Of Private Company ValuationPublicly traded companies are valued differently than private companies are. In order to value a publicly traded business, all you need to do is look at the total number of shares outstanding, and multiply that by the company's current share price. This will give you the market capitalizationā?"or the total value of the company's stock. The stock market values publicly traded companies every trading day through the current share price. This valuation is reliable because it automatically adjusts as these shares are bought and sold in the open market.
Private companies are more difficult to value for a few reasons. First, they don't publish detailed financial information that is available to the public. Generally, in mergers and acquisitions, private company financial data is distributed in stages, taking care to protect the seller's identity throughout the process.
Additionally, private company financial statements can be inconsistent because they are not held to the same level of scrutiny that publicly traded companies are.
We'll look at four common ways that private companies are typically valued next.
Understanding Private Company ValuationValuing a private company is an art and science that requires expertise, knowledge, and experience. Private companies are not publicly traded, so the stock market cannot be used to determine their value.
Instead, there are four primary methods of valuing a private company: analyzing comparable companies; looking at precedent transactions; discounting cash flows; and directly valuing the business's assets.
Generally, the goal in business valuation is not to come up with a specific "number" but instead to come up with a range of valuations based on different methods so that a prospective buyer can see what a business is worth from a variety of perspectives. We recommend our guide - Intro to Private Company Valuation - to learn more about the steps involved in this process.
Here are four common methods used:
The asset valuation method is the most straightforward way to value a business. To value the assets of a business, we take the total assets the business has, subtract intangible assets, subtract any debt the business has, and we arrive a net tangible assets. This is the assumed value of the assets that could be sold.
- Asset Valuation Method
- Discounted Cash Flow (DCF) Method
- Comparable Company Analysis
- Precedent Transactions
The discounted cash flow method involves looking at the business from the perspective that it is an asset that will continue to produce future cash flows into the future. Here, we look at the values of those expected future cash flows and we discount them back in time to their net present value. This shows us what it would be worth paying today for those future cash flows.
Additionally, we can sometimes do a valuation through comparable company analysis. Here, we look at publicly traded companies that are similar and we see what they are trading for above earnings. Since these are publicly traded companies we need to also account for the liquidity premium their valuation gives. It's easier to sell a stock than shares in a private company, so we apply a liquidity discount to that valuation to make it more realistic for a private company. We can then get a potential valuation through what the shares of those comparable companies are selling for in the open market.
Finally, we can value a business through precedent transactions. This method assumes we can find market data for other privately held businesses that have been sold and we can see what a buyer paid them as a multiple above earnings. Since there are normally multiple offers made to buy a business, we can use these precedent transactions to justify to prospective buyers that our business is worth this amount.