The valuation of a private company is the process that evaluates the current worth of the business. Valuation is a set of procedures used to appraise the value of a company.
There can be numerous reasons for the valuation of a company. For businesses, valuation can help track their progress, success, and performance in the market to the competitors. Whereas, investors can use the valuation of the company to evaluate the potential investment a business requires.
When valuing a company, we suggest using more than one method because no single valuation method can determine the standard valuation of a company. In this write-up, we will discuss two different generally used valuations of a private company method, including Comparable Company Analysis (CCA) and Discounted Cash Flow (DCF) Method, and their limitations.
To evaluate the value of a company, the comparable company analysis method examines the other businesses of the same industry of the same size, considering they have identical multiples.
Simply put, when the financial information of the company is not public, we explore companies similar to our target private company and determine the value using the comparable company analysis method.
In this method, the factors we find and consider include industry, size, operations, and more. We collect these lookalike companies and create a peer group of them. These companies collectively enable us to calculate the industry average.
Though the multiples of a business depend on the industry type and the growth stage, most of the time we use EBITDA to base the valuation.
The EBITDA represents earnings before interest, taxes, depreciation, and amortization which can be used as approx free cash flow of the said firm. We implement this method using the following formula –
Value of target firm = Multiple (M) x EBITDA of the comparable firm
Here, the Multiple(M) represents the average of the comparable firm’s enterprise value/EBITDA.
Limitations of Comparable Company Analysis Method –
The formula can get influenced by non-fundamental factors easily as most of the data of the private companies are not available. Next, it can be challenging to find a bunch of right comparable companies. Besides, as all companies have their unique stances, the valuation of the private company can get manipulated.
Discounted cash flow method is used to estimate the value of the investment made today by calculating the expected future cash flows. We estimate the cash flow of the targeted company using their acquired publicly-traded financial information.
To start with the DCF method, we define the revenue growth rate of the target firm by calculating its average growth rate. Based on that evaluation, we make the five-year projections of the company’s expenses, taxes, revenue, free cash flow, and more. The formula to calculate free cash flow is:
Free cash flow = EBIT (1-tax rate) + (depreciation) + (amortization) – (change in net working capital) – (capital expenditure)
We take the firm’s weighted average cost of capital (WACC) as the discount rate (approximately). To determine WACC, estimating the cost of debt, cost of equity, capital structure, and the tax rate is vital. Estimate the equity cost using the CAPM method (Capital Asset Pricing Model). You can calculate the firm’s beta by getting the industry beta. Besides, the company’s debt depends on its credit profile which partially affects the interest rate at which it has incurred debt.
To find out the tax rate and capital structure, we refer to the public peers of the targeted company. Having in hand cost to debt, debt and equity ratio, and cost of equity, we can easily calculate WACC.
Formula to calculate the WACC is:
E/D+W (re) + D/D+E(rd) (1-t)
E = Stands for equity’s market value
D = Stands for the market value of debt
re = Stands for the cost of equity
rd = Stands for the cost of debt
T = Stands for corporate tax rate
The formula to calculate the targeted firm’s valuation is –
FCF1/1+WACC + FCF2/(1+WACC)2 +…+ FCFn (1+WACC) n
Limitations of Discounted Cash Flow (DCF) Method
The company takes into account the expected rate of return on the current investment, which we also term as expected future cash flow. However, as the estimation of the future cash flow is based completely on the guesswork, it can make the estimation inaccurate.
As we can see, the entire valuation of a private company is based on the assumption every stage of the valuation requires adjusting to the more reliable figures and estimations, eliminating the effects of rare events. However, as in these calculations, the assumptions are made on industry trends; it requires experts and an experienced team to forecast the fairest assumptions.
Want to estimate the overall value of a private company most accurately? Get in touch with us and let our team of experts define the value of your company. Wiley Financial Services is an accounting service provider that has over 20 years of experience serving a variety of industries. Talk to us to know more.
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