Introduction
How to value private companies? Company and investor valuations are essential. Organizations can use valuations to measure their progress and market performance. Valuations can be used to determine the worth of possible investments. They make use of information and data that is available to the public from these corporations. What the company is currently worth in monetary terms. Valuing a publicly traded company is less complicated than privately held businesses. They are considering the wealth of information and data made available by publicly traded companies.
It is through a "valuation" that the worth of a privately held business is calculated. Companies trading on public exchanges can quickly achieve this by looking at their stock's price and volume in stock databases—the market capitalization of a publicly traded firm. Since private corporations do not have public stock prices, they cannot use this strategy. Since privately held companies are not required to comply with the same regulations as publicly traded companies, it can be more difficult to analyse their financial health based on their financial statements alone.
Methods Typically Used to Estimate the Worth of a Private Company
Critical Comparison to Competitors (CCA)
The CCA method is predicated on the hypothesis that companies in the same industry trade at similar multiples. When valuing a firm whose financials are not publicly available, we look for similar businesses and apply the multiples from those valuations to our target company. This is the approach of choice when valuing a private company. A "peer group" of comparable businesses is identified and formed to implement this strategy. These "peers" are chosen based on their shared characteristics with the target firm, such as size, industry, operation, etc. After tallying up the multiples of all relevant companies, we can calculate the average market multiple.
One of the most popular multiples is the earnings before interest, taxes, and amortisation (EBITDA) multiple, which we use as an example; however, the optimal multiple will vary depending on the industry and the maturity level of the company. EBITDA, or earnings before interest, taxes, depreciation, and amortisation, approximates a company's free cash flow. The value of the firm is calculated using the following formula: Multiplying the target company's EBITDA by the multiple yields the company's value (M). It is common to calculate a company's Multiple by dividing its Enterprise Value by its anticipated earnings before interest, taxes, depreciation, and amortisation (EBITDA) for the following fiscal year (M).
Using the Discounted Cash Flow (DCF) Model
Discounted Cash Flow (DCF) is an extension of the CCA method. The first stage of DCF is forecasting the company's long-term profit growth. As a result, we take an average of the expansion rates of comparable businesses. After that, we predict the target company's revenue, operational expenses, taxes, and so on for five years and use that information to calculate free cash flows (FCF). The formula for determining free cash flow is:
- Free cash flow = operating income - tax rate - depreciation - amortisation - the difference in working capital (capital expenditure)
The WACC is the most acceptable discount rate to use for this company (weighted average cost of capital). It is possible to determine a firm's weighted average cost of capital by analysing its cost of equity, cost of debt, tax rate, and capital structure (WACC). When calculating the stock price, the Capital Asset Pricing Model (CAPM) is typically utilised (CAPM). The company's beta was determined by taking the sector beta and averaging the two. The rate of interest at which the target pays for borrowing money is a direct result of its creditworthiness.
One Chicago Approach
The First Chicago Method is a method for valuing a company that combines the advantages of multiples analysis with discounted cash flow. This novel strategy considers various potential outcomes for the target company's profitability. Using this method, you can prepare for multiple products, including the best case (which is what the company aims for in its business plan), the base case (which is the most likely event), and the worst case. Possibilities in each scenario are weighted differently. Using the Gordon Growth Model, we also make long-term projections for the company's value. After that, each case calculates a value using the DCF method. Finally, the target firm's value is determined by averaging the three possible outcomes, weighted by their relative probabilities.
Conclusion
Many assumptions, educated guesses, and averages are used to determine a private company's worth. Privately held companies have less available information, making it more challenging to assign an accurate value. The private equity sector and corporate finance advisory teams employ alternative approaches to company valuation.
