A:

Share ownership in a private company is usually quite difficult to value due to the absence of a public market for the shares. Unlike public companies that have the price per share widely available, shareholders of private companies have to use a variety of methods to determine the approximate value of their shares. Some common methods of valuation include comparing valuation ratios, discounted cash flow analysis (DCF), net tangible assets, internal rate of return (IRR), and many others.

The most common method and easiest to implement is to compare valuation ratios for the private company versus ratios of a comparable public company. If you are able to find a company or group of companies of relatively the same size and similar business operations, then you can take the valuation multiples such as the price/earnings ratio and apply it to the private company.

For example, say your private company makes widgets and a similar-sized public company also makes widgets. Being a public company, you have access to that company's financial statements and valuation ratios. If the public company has a P/E ratio of 15, this means investors are willing to pay $15 for every $1 of the company's earnings per share. In this simplistic example, you may find it reasonable to apply that ratio to your own company. If your company had earnings of $2/share, you would multiply it by 15 and would get a share price of $30/share. If you own 10,000 shares, your equity stake would be worth approximately $300,000. You can do this for many types of ratios: book value, revenue, operating income, etc. Some methods use several types of ratios to calculate per-share values and an average of all the values would be taken to approximate equity value.

DCF analysis is also a popular method for equity valuation. This method utilizes the financial properties of the time-value of money by forecasting future free cash flow and discounting each cash flow by a certain discount rate to calculate its present value. This is more complex than a comparative analysis and its implementation requires many more assumptions and "educated guesses." Specifically, you have to forecast the future operating cash flows, the future capital expenditures, future growth rates and an appropriate discount rate. (Learn more about DCF in our Introduction to DCF Analysis.)

Valuation of private shares is often a common occurrence to settle shareholder disputes, when shareholders are seeking to exit the business, for inheritance and many other reasons. There are numerous businesses that specialize in equity valuations for private business and are frequently used for a professional opinion regarding the equity value in order to resolve the issues listed.

For more, read Analyze Investments Quickly With Ratios.

This question was answered by Joseph Nguyen.

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