Lesson 7.5: Private Company and Industry Valuation

Introduction

In the world of finance, valuing companies is essential for investment decisions, particularly when considering equity investments. This lesson focuses on two critical aspects: the valuation of private companies and the use of industry analysis to frame these valuations. As candidates for the CFA Level II exam, you will discover various valuation approaches and the nuances of applying discounts unique to private companies. This lesson will equip you with the knowledge to effectively analyze and value private businesses while considering extensive industry context.

Learning Objectives

By the end of this lesson, you will be able to:

Understand valuation approaches and the specific discounts applicable to private companies.
Conduct industry and competitive analysis to establish a strong valuation context.
Calculate the value of a private company and apply appropriate discounts.
Use insights derived from industry analysis to support your valuation assumptions.
Navigate key terms and concepts related to private company and industry valuation.

Private Company Valuation Approaches

Valuing a private company can be significantly different from valuing a publicly traded one. Private companies do not have a readily available market price, making it essential to utilize other methods for valuation. Here are some common approaches:

1. Income Approach

The income approach considers the company's ability to generate future cash flows. Two prominent methods under this approach are:

a. Discounted Cash Flow (DCF) Method

The DCF method forecasts the company’s free cash flows and discounts them back to their present value using a required rate of return. The formula for the present value of future cash flows is given by:

$PV = \sum_{t=1}^{n} \frac{FCF_t}{(1 + r)^t}$

where:

$PV$ = Present Value
$FCF_t$ = Free Cash Flow at time $t$
$r$ = Discount rate
$n$ = Total number of periods

Example: Consider a private company that expects to generate free cash flows of $100,000, $120,000, and $140,000 over the next three years. If the required rate of return is 10%, the present value of future cash flows is calculated as follows:

Year 1: $PV = \frac{100,000}{(1 + 0.1)^1} = \frac{100,000}{1.1} = 90,909.09$
Year 2: $PV = \frac{120,000}{(1 + 0.1)^2} = \frac{120,000}{1.21} = 99,173.55$
Year 3: $PV = \frac{140,000}{(1 + 0.1)^3} = \frac{140,000}{1.331} = 105,173.03$

Total PV = $90,909.09 + 99,173.55 + 105,173.03 = 295,255.67$

b. Capitalization of Earnings Method

This method estimates the company’s value based on its expected future earnings. The formula is:

$Value = \frac{E}{r}$

where:

$E$ = Expected earnings
$r$ = Capitalization rate

Common Misconceptions

Misconception: All private companies should be valued using the DCF method.
Clarification: While the DCF method is popular, if a company has inconsistent cash flows, other methods such as the capitalization of earnings may yield better results.

Discounted Cash Flows for Private Companies

A significant challenge in valuing private companies is determining an appropriate discount rate. Since private companies carry unique risks, the discount rate often incorporates a premium for illiquidity and size risk.

2. Market Approach

The market approach determines a company's value based on similar transactions or publicly traded companies. It involves the use of multiples derived from comparable companies or transactions. The major multiples used include:

Price to Earnings (P/E) Ratio
Price to Sales (P/S) Ratio

Example of Market Multiple Valuation

Assume you have identified several comparable companies with P/E ratios of 15, 18, and 20. If the private company’s expected earnings are $200,000, the average P/E ratio is:

Average P/E = $\frac{15 + 18 + 20}{3}$ = 17.67

Using the average P/E to estimate the private company's value:

Value = Earnings $\times$ Average P/E = 200,$000 \times 17$.67 = 3,534,000

Applying Discounts for Private Companies

When valuing private companies, certain adjustments are often necessary to account for their illiquidity and lack of marketability. Two common discounts applied are:

1. Discount for Lack of Marketability (DLOM)

This discount is applied due to the inherent difficulty in liquidating ownership stakes in private companies. A typical DLOM can range from 20% to 40%, but the specific discount depends on various factors such as the company’s financial health and industry classification.

2. Discount for Lack of Control

This discount accounts for the potential loss of control associated with minority interests in private companies. In general, this discount ranges from 10% to 30%.

Example of Applying Discounts

Assume a private company is valued at $1,000,000 without discounts. After applying a DLOM of 25% and a lack of control discount of 20%, the final value is calculated as follows:

Apply DLOM: $1,000,000 - (0.25 \times 1,000,000) = $750,000
Apply Lack of Control Discount: $750,000 - (0.20 \times 750,000) = $600,000

Industry and Competitive Analysis

Industry analysis involves examining trends and competitive forces within a sector that affects a company’s valuation. Understanding the broader industry context can provide insights into growth potential, risks, and the effectiveness of the company's strategy.

1. Key Components of Industry Analysis

When conducting an industry analysis, consider the following components:

Market Size and Growth Prospects
Competitive Landscape (Porter’s Five Forces)
Regulatory Environment
Economic Conditions

Example: Porter’s Five Forces

Porter’s Five Forces is a framework that provides a structured way to analyze industry competitiveness. It consists of:

Threat of new entrants
Bargaining power of suppliers
Bargaining power of customers
Threat of substitute products
Rivalry among existing competitors

Example Analysis: In a growing technology sector, if new entrants are deterred by high capital requirements (low threat of new entrants), suppliers have moderate power, customers have high bargaining power, substitutes are plentiful, and competition is fierce, you can derive insights about the pricing power and profitability of firms within the industry.

Conclusion

Valuing private companies involves unique challenges and requires a comprehensive understanding of various methods and applicable discounts. Combining these methods with a thorough industry analysis enables analysts to derive more accurate valuations and make more informed investment decisions. As students, you should now possess the foundational skills to approach private company valuations effectively in the context of equity investments.

Study Notes

Valuation of private companies (Income and Market Approaches).
Discounted Cash Flows and Capitalization of Earnings are key methods.
Essential to apply appropriate discounts: DLOM and Lack of Control Discounts.
Industry analysis (Porter’s Five Forces) informs valuation context.
A thorough understanding of industry dynamics is critical for accurate valuations.