How Private Companies are Valued

Private company valuation follows a significantly different procedure compared to public company valuation. The value of public companies is simply calculated as the product of its stock price and number of shares outstanding. For valuing private companies, on the other hand, there are three common methods that use publicly available data.

Method 1: Comparable Company Analysis (CCA)

The CCA method uses a key assumption that similar businesses in the same industry have similar multiples. When the private company’s financials are not publicly available, one must search for similar companies and use their multiples to determine the target firm’s value.

The first step is to identify key characteristics of the target firm, such as size and industry, and then compile a list of companies that share those traits. One can then take each company’s multiple and calculate the industry average.

The firm is then valued as follows:

Value of target firm = Multiple (M) x EBITDA of target firm,

where the Multiple (M) is the average of Enterprise Value / EBITDA of comparable firms

Note: The EBITDA of the target firm is typically projected for the next 12 months.

Method 2: Discounted Cash Flow (DCF) Method

The DCF method starts takes the CCA method one-step further. One must start by determining the applicable revenue growth rate for the target firm which is the average of comparable firms’ growth rates. One must then make projections of the firm’s revenue, operating expenses, taxes, etc. and generate Free Cash Flows (FCF) of the target firm, typically for 5 years. 

Free Cash Flow is calculated as follows:

FCF = EBIT x (1 - Tax Rate) + Depreciation + Amortization - Change in Net Working Capital - Capital Expenditure

The firm’s Weighted Average Cost of Capital (WACC) is typically used as the appropriate discount rate. To derive WACC, one must know the firm’s cost of equity, cost of debt, tax rate, and capital structure. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM), while the firm’s beta is estimated using the industry average beta. Once one has the weights of both debt and equity, cost of debt, and cost of equity, one can derive the WACC. The target firm is finally valued by summing the FCFs once they are discounted to the present value.

Method 3: First Chicago Method

The First Chicago Method is a combination of the first two methods discussed. What is unique about this method, however, is that it takes into consideration various scenarios of the target firm’s payoffs. This method typically constructs three scenarios: best-case (as stated in the firm’s business plan), a base-case (most likely scenario), and a worst-case scenario. Each case is then assigned a probability.

The same approach as the first two methods is then applied to project cash flows and growth rates for a five-year forecast period for the specific cases. The valuation of each case is derived using the DCF method. Finally, the target firm is valued by taking the probability-weighted average of the three scenarios. This valuation method is often used as it incorporates the firm’s upside potential and downside risk.

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