While most investors are versed in ins and outs of equity and debt financing of publicly-traded companies, few are as well-informed about their privately-held counterparts. Private companies make up a large proportion of businesses in America and across the globe; however the average investor most likely cannot tell you how to assign a value to a company that does not trade its shares publicly. This article is introduction to how one can place a value on a private company and the factors that can affect that value.

Private and Public Firms
The most obvious difference between privately-held companies and publicly-traded companies is that public firms have sold at least a portion of themselves during an initial public offering (IPO). This gives outside shareholders an opportunity to purchase an ownership (or equity) stake in the company in the form of stock. Private companies, on the other hand, have decided not to access the public markets for financing and therefore ownership in their businesses remains in the hands of a select few shareholders. The list of owners typically includes the companies' founders along with initial investors such as angel investors or venture capitalists.

The biggest advantage of going public is the ability to tap the public financial markets for capital by issuing public shares or corporate bonds. Having access to such capital can allow public companies to raise funds to take on new projects or expand the business. The main disadvantage of being a publicly-traded company is that the Securities and Exchange Commission requires such firms to file numerous filings, such as quarterly earnings reports and notices of insider stock sales and purchases. Private companies are not bound by such stringent regulations, allowing them to conduct business without having to worry so much about SEC policy and public shareholder perception. This is the primary reason why private companies choose to remain private rather than enter the public domain.

Although private companies are not typically accessible to the average investor, instances do arise where private firms will seek to raise capital and ownership opportunities present themselves. For instance, many private companies will offer employees stock as compensation or make shares available for purchase. Additionally, privately-held firms may also seek capital from private equity investments and venture capital. In such a case, those making an investment in a private company must be able to make a reasonable estimate of the value of the firm in order to make an educated and well researched investment. Here are few valuation methods one could use. (For a related reading, see Why Public Companies Go Private.)

Comparable Company Analysis
The simplest method of estimating the value of a private company is to use comparable company analysis (CCA). To use this approach, look to the public markets for firms which most closely resemble the private (or target) firm and base valuation estimates on the values at which its publicly-traded peers are traded. To do this, you will need at least some pertinent financial information of the privately-held company.

For instance, if you were trying to place a value on an equity stake in a mid-sized apparel retailer, you would look to the public sphere for companies of similar size and stature who compete (preferably directly) with your target firm. Once the "peer group" has been established, calculate the industry averages. This would include firm-specific metrics such as operating margins, free-cash-flow and sales per square foot (an important metric in retail sales). Equity valuation metrics must also be collected, including price-to-earnings, price-to-sales, price-to-book, price-to-free cash flow and EV/EBIDTA among others. Multiples based on enterprise value should give the best interpretation of firm value. By consolidating this data you should be able to determine where the target firm falls in relation to the publicly-traded peer group, which should allow you to make an educated estimate of the value of an equity position in the private firm.

Additionally, if the target firm operates in an industry that has seen recent acquisitions, corporate mergers or IPOs, you will be able to use the financial information from these transactions to give an even more reliable estimate to the firm's worth, as investment bankers and corporate finance teams have determined the value of the target's closest competitors. While no two firms are the same, similarly sized competitors with comparable marketshare will be valued closely on most occasions. (To learn more, check out Peer Comparison Uncovers Undervalued Stocks.)

Estimated Discounted Cash Flow
Taking comparable analysis one-step further,one can take financial information from a target's publicly-traded peers and estimate a valuation based on the target's discounted cash flow estimations.

The first and most important step in discounted cash flow valuation is determining revenue growth. This can often be a challenge for private companies due to the company's stage in its lifecycle and management's accounting methods. Since private companies are not held to the same stringent accounting standards as public firms, private firms' accounting statements often differ significantly and may include some personal expenses along with business expenses (not uncommon in smaller family-owned businesses) along with owner salaries, which will also include the payment of dividends to ownership. Dividends are a common form of self-payment for private business owners, as reporting a salary will increase the owner's taxable income, while receiving dividends will lighten the tax-burden.

What's important to remember is that estimating future revenue is only a best guess estimate and one estimate may differ wildly from another. That is why using public company financials and future estimates is a good way to augment your estimates, making sure that the target's sales growth is not completely out of line with its comparable peers. Once revenues have been estimated, free cash flow can be extrapolated from expected changes in operating costs, taxes and working capital.

The next step would be to estimate the target firm's unlevered beta by gathering industry average betas, tax rates and debt/equity ratios.

Next, estimate the target's debt ratio and tax rate in order to translate the industry averages to a fair estimate for the private firm. Once an unlevered beta estimate is made, the cost of equity can be estimated using the Capital Asset Pricing Model (CAPM). After calculating the cost of equity, cost of debt will often be determined by examining the target's bank lines for rates at which the company can borrow. (To learn more, see The Capital Asset Pricing Model: An Overview.)

Determining the target's capital structure can be difficult, but again we will defer to the public markets to find industry norms. It is likely that the costs of equity and debt for the private firm will be higher than its publicly-traded counterparts, so slight adjustments may be required to the average corporate structure to account for these inflated costs. Also, the ownership structure of the target must be taken into account as well as that will help estimate management's preferred capital structure as well. Often a premium is added to the cost of equity for a private firm to compensate for the lack of liquidity in holding an equity position in the firm.

Lastly, once an appropriate capital structure has been estimated, calculate the weighted average cost of capital (WAAC). Once the discount rate has been established it's only a matter of discounting the target's estimated cash flows to come up with a fair value estimate for the private firm. The illiquidity premium, as previously mentioned, can also be added to the discount rate to compensate potential investors for the private investment.

The Bottom Line
As you can see, the valuation of a private firm is full of assumptions, best guess estimates and industry averages. With the lack of transparency involved in privately-held companies it is a difficult task to place a reliable value on such businesses. Several other methods exist that are used in the private equity industry and by corporate finance advisory teams to help put a value on private companies. With limited transparency and the difficulty in predicting what the future will bring to any firm, private company valuation is still considered more art than science. (To learn more, see For Companies, Staying Private A Matter Of Choice.)

Related Articles
  1. Entrepreneurship

    How Does ClassPass Work and Make Money?

    Find out how ClassPass makes money, how the company aims to help both businesses and consumers, and why it has been so successful.
  2. Fundamental Analysis

    How WeWork Works and Makes Money

    Find out how WeWork makes money by offering flexible, shared office space to out-of-the-cubicle workers like freelancers and entrepreneurs.
  3. Stock Analysis

    Startup Analysis: How Much Is Snapchat Worth?

    Learn about Snapchat's multibillion dollar valuation and how it is part of a new breed of private companies known as unicorns for their high valuations.
  4. Stock Analysis

    Analyzing Home Depot's Return on Equity (ROE)

    Discover what Home Depot's return on equity (ROE) ratio says about the performance of the company and how it relates to historical averages and industry trends.
  5. Stock Analysis

    If You Had Invested Right After Kraft's IPO

    Discover the complicated history of the Kraft Heinz Company and how much an investment in its initial public offering in 2001 would be worth today.
  6. Investing

    How to Take Maternity Leave as a Freelancer

    Freelancers are not covered under the Family and Medical Leave Act, but maternity leave is still doable with these tips.
  7. Investing

    Asset Manager Ethics: Acting With Competence and Diligence

    Managers must make investment decisions based on their personal investment process, which in turn should be based on solid research and due diligence.
  8. Forex Education

    Understanding The Income Statement

    Learn how to use revenue and expenses, among other factors, to break down and analyze a company.
  9. Stock Analysis

    If You Had Invested Right After Coca-Cola's IPO

    Discover how one $40 share, with dividend reinvestment, over 90 years ago in the Coca-Cola Company would have made you a multimillionaire today.
  10. Professionals

    How To Hire and Retain An Overqualified Candidate

    Understand how to hire and retain overqualified candidates by proactively seeking them out, discerning their motivations and then offering what they want.
  1. Why are high net worth divorces considered more challenging than other divorce cases?

    All divorces are emotionally difficult and create a financial strain on the parties involved. As it pertains to dividing ... Read Full Answer >>
  2. What are some examples of return on investment capital?

    Return on invested capital (ROIC) shows the percentage return on money provided by bondholders and shareholders. Examples ... Read Full Answer >>
  3. When did Facebook go public?

    Facebook, Inc. (NASDAQ: FB) went public with its initial public offering (IPO) on May 18, 2012. With a peak market capitalization ... Read Full Answer >>
  4. Do working capital funds expire?

    While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
  5. Who decides if a financial security should be escheated?

    There is no one entity who "decides" to escheat assets. Rather, financial institutions are required to report inactive accounts ... Read Full Answer >>
  6. How does escheatment impact a company?

    In recent years, state governments have become increasingly aggressive in enforcing escheatment laws. As a result, many businesses ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  5. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
Trading Center