3 Effective Methods for Private Company Valuations

“What is the net worth and value of my business?” – this is one of the most common questions that private company owners ask. Private company valuation allows business owners to appraise their company’s current worth. Business valuations can help a private company track its mergers and acquisitions (M&A), analyze the acquisition targets, and keep track of its portfolio performance. However, private companies might come across a few challenges while valuing their assets. We list out three effective methods for private company valuation to help you choose the best for your company.

Private Company Valuation Methods

There are three basic valuation procedures utilised by industry practitioners when valuing a firm. Before moving on to the methods of private company valuations, it's crucial to know what a private company valuation is and what it entails.

Understanding Private Company Valuation

Private firm valuation is a set of procedures that a company uses to determine its current worth. It is essential to note that company valuation is quite simple for a publicly traded company. Just by retrieving the company's number of outstanding shares and stock prices, you can determine its net worth. Also, it is easy to find such details about a publicly traded company on the internet, and market capitalization, or the public company's value, is nothing but the sum of the two values.

When it comes to private company valuation, the process involves a few additional steps and measures. A private company valuation will reveal the per-share value of its equity. In turn, this equity value will indicate the performance of the company in the market. The private company valuation reports are also the basis for equity financing. Investors look for these reports to find assurance over the safety of their investments. As you read this article, you’ll understand more about the need, limitations, and methods for private company valuation.

Need for Private Company Valuation

With such complications involved in the valuation process, you might be wondering about the importance of private company valuation. Private company valuation has multiple benefits and are not only crucial for the private firm themselves, but also for their potential investors.

For starters, valuations of private firms are vital for themselves but also for investors. It allows them to measure their success and progress. Additionally, it can be a helpful tool to compare their performance to other businesses in the market. It is also worth mentioning that investors highly desire the reports from such analysis. Investors often look up to valuation reports to understand the worth of their investments.

A private company might be interested in the valuation process when it comes to raising funds. The firm might want to seek capital from venture capital and private equity investments. In such a case, anyone interested in investing will want to look at the firm’s value.

A private firm might also need to evaluate their net worth if they plan to issue an employee stock option. The valuation process helps a private company to discover its strengths and weaknesses.

Limitations with Private Company Valuation

Private company valuation is challenging and demands a meticulous and experienced approach. Although the information is often more challenging to obtain for private companies, values can nevertheless be calculated using the available information.

Though considering the industry average in terms of growth rates and multiples can give you a near-exact value, it cannot reflect extreme one-time events. For such cases, you might need to adjust for a more accurate and precise rate.

Also, any recent IPOs or mergers and acquisitions in the industry can help you have a more precise valuation. Despite the limitations, private company valuation is by and large preferred by most firms. It is also worth mentioning that the valuation reports can serve as great tools when it comes to buying or selling other firms.

3 Methods for Private Company Valuation

Several methods exist for private company valuation. But, since transparency is a limitation here, some ways offer better results than others. Below, you can find three private company valuation methods:

1. Comparable Company Analysis (CCA)

The Comparable Company Analysis (CCA) method is one of the most frequently used methods for the valuation process of a private company. This method works on the principle of comparing specific metrics of the private firm with other firms that are similar in terms of operation and size. In short, a CCA compares a private company to another company in the public domain.

For performing a comparable company analysis, you need to have a proper selection of relevant peer companies. You might need to turn down a few potential peer companies because they operate across different industries. In simpler words, the selection of peer companies is a subjective concept. While conducting CCA, companies can either opt for trailing performance metrics or future performance metrics.

These are the few key projections one needs to make when performing a CCA:

• EPS: Historical and projected earning per share
• EBITDA: Historical and projected earnings before interest, tax, depreciation & amortization
• Peer universe: Selection of competitor

You might be curious to know the advantages of this approach. For starters, it is simple to calculate using widely available data. Besides, CCA provides a valuable way to estimate market assumptions of fundamental characteristics. The communication for the CCA approach also happens to be straightforward.

One of the common multiples for the process is EBITDA. EBITA is usually predicted for 12 months and is an estimate of the firm’s cash flow. The CCA private company valuation formula is as follows:

Value of Target Private Firm = EBITDA of the firm x Multiple (M)

In the above equation, Multiple (M) = Average of Enterprise Value / EBITDA of peer firms

2. Discounted Cash Flow (DCF) Method

The Discounted Cash Flow Method (DCF) is another method that can help private firms complete the valuation process. This method follows a principle that is based on estimating the company’s future discounted cash flows. It is worth mentioning that this method is a step ahead of the Comparable Company Analysis method.

DCF is applicable to decisions of investors in securities companies such as buying a stock or acquiring a company. DCF analysis applies to any situation where an individual is paying money right now with hopes of receiving more in return in the future. The investor must estimate future cash flows, ending value of equipment, investment, and other similar assets.

Similar to the CCA method, the DCF method requires financial metrics of peer companies in the public sector. Analysts first start by calculating the average growth rates for the selected peer companies. The next step includes projecting the private company's taxes, revenues, and expenses to generate a free cash flow (FCF). Typically, FCF calculation is done for five years.

Free cash flow (FCF) = EBIT (1 – tax rate) + (depreciation) + (amortization) – (change in networking capital) – (capital expenditure)

WACC or a weighted average cost of capital is an accurate discount rate used in this valuation method. WACC offers a sense of the cumulative cost of capital inclusive of debt and equity.

Therefore, the equation for calculating the valuation of the target firm is:

FCF1 / 1 + WACC + FCF2 / (1+WACC)2 + ........... + FCFn / (1 + WACC)n

3. First Chicago Method

This method of private company valuation is a combination of DCF and multiples methods. Generally, VCs and Angels use this method. One big reason VCs and Angels use this method is that it gives them insights into a dynamically growing firm.

One of the greatest perks of this method is its comprehensiveness. Every calculation in the First Chicago method is based on the precise estimates of the values in the future and the cash flows. Since it takes into account the high-risk scenarios, it might help business owners overcome potential threats.

Here’s a step-by-step process of the First Chicago Method:

• Projection of Three Scenarios: The three scenarios are the worst case, best case, and base case. Here, the worst-case refers to the complete loss of investment. Next, the process involves forecasting financial scenarios such as exits, cash flow, and earnings of the private firm. This step includes different metrics that you should use judiciously to arrive at accurate results. We advise you to engage a professional business valuation company for a smooth process.
• Use of Multiples: The second step involves using the multiples method to determine the terminal value of the private company in the target. If you are not aware, the terminal value is a forecast of the firm's value when an investor decides to exit. For the multiples method, the selection of peer companies is critical. It is primarily based on the private firm's size of operation, growth stage, state or country of incorporation, and industry.
• Valuation of Three Cases: Lastly, the DCF model determines the valuation of all three cases. The concluding valuation of the private company is arrived at by considering the probability-weighted average of the three scenarios. Moreover, VCs and Angels may also have internal calculations like WACC that alter due to the limitation of reliable financial data.

Valuate your Company

You can see that private company valuation is all about guess estimates, industry averages, and projections. One of the biggest challenges in private company valuations is transparency. Due to the restricted transparency in private firms, it's impossible to put an absolute value. The three methods listed in this article are your best bet for how to value a private company.