FR2203: L7 (Private Company Valuation & Diversification Discount)

company/stock-specific factors

factors characterizing the firm/stock of the firm

private company specific factors (7) (IN GENERAL)

• stage: early w/ minimal capital/assets/employees

• size: smaller w/ higher risk premium/lower growth opportunities

• SH/management: overlapping

• quality/depth of management: less attractive to management candidates

• financial info quality: less required, higher burden for prospective investors

• investor pressure: less pressure, can focus on LR investment

• taxes: more important

private company stock specific factors (3) (IN GENERAL)

• liquidity: less liquid (less SHs, not publicly registered)

• capital concentration: less SHs

• share restrictions: potential agreements prevent SHs from selling

key takeaway from private firms company/stock specific factors

generally, stock-specific factors are a negative for private firms and company-specific factors can be negative or positive

3 purposes of private valuation

1. transaction related

2. compliance related

3. litigation related

transaction related

events affect firm ownership/financing

types of compliance related purposes

• financial reporting

• tax reporting

3 private valuation approaches

1. income approach

2. market approach

3. asset-based approach

income approach

values asset as the PV of income expected from it

3 forms of the income method

1. FCF method

2. CCM method

3. EEM method

FCF method

values asset based on PV of future CF estimates

capitalization CF method (CCM)

values by using a single representative estimate of economic benefits divided by capitalization rate

• Vf = FCFF/(WACC-g)

• Ve = FCFE/(r-g)

stable growth, single-stage FCF used for smaller private firms w/ low growth prospects

capitalization rate

r-g

excess earnings method (EEM)

estimates value of all intangibles by capitalizing future earnings in excess of estimated return requirements associated w/ WC and fixed assets

• used for small private companies w/ significant unrecognized intangibles

size premium

premium added for smaller market cap firms

CAPM for private firms

same but ß is based on market data of public comps

expanded CAPM

r = CAPM + prem(small size) + prem(company-specific risk)

Build up approach

r = E(Rf) + E(Rm-Rf) + prem(industry risk) + prem(small size) + prem(company-specific risk)

• ß assumed to be 1

• used when public comps are questionable

market approach

values asset based on pricing multiples from sales of comps

asset-based approach

values firm based on values of underlying assets of the entity less the value of related liabilities

• rarely used for GC firms

what approach to choose for private firm valuation

based on life cycle stage

• early: asset-based

  • hard to predict FCF

  • GC uncertain

• mature/stable: market approach

• high-growth development: income approach

  • ex. disruptive firms (ex. uber) have no comps

diversification/conglomerate discount

a diversified firm (MS) on avg has a lower market valuation than an equivalent collection of focused firms (SS)

measuring conglomerate discount

q ratio = MV of total A/BV of total A

• compare actual q against q of synthetic benchmark firm constructed w/ matched SS firms

• discount exists if actual q < imputed q

excess value

log(actual q/imputed q)

• discount: xv < 0

• no dis/prem: xv = 0

• premium: xv > 0