Group02 Valuing Private Businesses

7/31/2019 Group02 Valuing Private Businesses

1/25

VALUATION OF PRIVATE BUSINESSES


2/25

Valuation of Private companies

While valuing a private firm, the motive behind thevaluation can affect the value. In particular the value

attached to a private firm that may be going public is

different from the one which is being valued to be sold toanother private company or a publicly trading company.

The principles of valuation remain the same but the

estimation of the inputs are what is unique


3/25

Unlike publicly traded firms, the accounting

practices by private firms are loose andinconsistent Scarcity of information for the no. of years and

in the amount of the information available foreach year.

Reduced

regulatory andreporting

requirements

There is no constant updated price for equityand historical data.

Absence of a ready market also means thatliquidating the equity position is more difficultand expensive in private companies

Lack of marketvaluation

The owner of a private firm is likely to beclosely involved with the management andmay have a major chunk of his wealthinvested in the firm

Absence of demarcation may lead to themixing of personal and company expenses.

Delineation ofexpenses and

profits

What is so special about private firms?


4/25

The value of a private firm is the present value ofexpected cash flows discounted at an appropriatediscount rate.The differences between private firms and publiclytraded arises in the manner these inputs to thediscounted cash flow model are estimated.

Cash flows to Value

Growth and sustainbility of growth

Cash flows

Cost of Capital

Cost of Debt

Cost of EquityMarket Beta

Estimation of valuation inputs at private firms


5/25

No product revenue,little to no expensehistory Both income approachand the market

approach not reliable indetermining theenterprise value due to alack of revenue orexpense history. Asset approach whichrecognizes that asignificant portion of the

assets may lie inintangibles Another method whichis become popularrecently is the back-solve method, a specialform of market approach

that considers recentstock transactions of thecompany

Stage 1

No product revenue,but substantive expensehistory(Stage 2) No product revenue,but product development

near completion (Stage3) Similar approaches tostage 1 The income approachmight be used, but witha relatively high discountrate due to the

significant riskassociated with furthercash flows.

Stages 2 & 3 Some product revenue,first customer orders,initial shipments (Stage4) Product revenue andbreak-even/positive cashflows (Stage 5)

Established history ofprofitability and cashflows (Stage 6)In stage 4, the incomeand market approachesto be used with a lowerdiscount rate due to the

lower level of riskcompared with priorstages In stages 5 and 6,under the marketapproach, loweradjustments would berequired in comparing

the EV to publicly heldstart-up companies.

Stages 4, 5 &

6

eve opmen s ages v s- -v s va ua ontechniques


6/25

Starting with discount rates, if we want to value equity,we shall discount cash flows to equity at the cost ofequity, if we want to value the firm, we shall discountthe cash flows to the firm at the cost of capital

1. The investor is not diversified

2. Absence of historical data for computation of thebeta

Issues related to computation of cost of equity

The cost of equity


7/25

AccountingBeta

FundamentalBeta

Bottom UpBeta

PROCEDUREPrice information not available but accounting earnings are

available for private firms Regress changes in accounting earnings against changes inearnings for an equity index to estimate accounting beta Using operating earnings would yield unlevered beta Using net income would yield a levered beta

LIMITATIONS Measured once a year> Limited information and weak statisticalpower Earnings are normally smoothed out and subject to accountingjudgments

Approaches to estimate market Betas


8/25

Damodaran suggests the following regression that was run on the betas of

NYSE and AMEX stocks to 4 variables

1. CVOI: Coefficient of variation in operating income.2. Book debt/equity

3. Historical growth in earnings(g)

4. Book value of total assets(TA)

= 0.6507 + 0.25 CVOI1

+ 0.09 D/E + 0.54 g - 0.000009 TA R2=18%

Each of these variables for a private firm are measurable and can be used

to estimate the beta.

Note: 1. Coefficient of Variation in Operating Income = Standard Deviation in Operating Income/ Average Operating Income

AccountingBeta

FundamentalBeta

Bottom UpBeta



9/25

Estimate the average beta for publicly traded comparable firms

Estimate the average market value debt-equity ratio of these comparable firms andcalculate the unlevered beta for the business

To adjust the unlevered beta for the financial leverage, we may use one of the twoalternatives

(a) Assume the firms debt to equity ratio is converging with industry average.

(b) Use private firms target Debt to Equity or Optimal Debt to Equity (if it can beestimated)

Estimate cost of equity based on the estimated beta.

AccountingBeta

FundamentalBeta

Bottom UpBeta



10/25

The Beta of a firm measures only the market risk and is based on the assumptionthat the investor is well diversified. However, a private firm owner is likely to invest allor the bulk of their wealth invested in the business. Hence their perceived cost ofequity is different.

Likely to adjust market beta with total risk measure under following situations: Whenvaluing a private firm for

Sale to a private business

Total Risk= Market Beta/ Correlation with the Market

Total Risk vs Market Risk

The total Beta will be higher than the market beta, the lower the correlation betweenthe market and the private firm the higher the total beta

Adjustment for Non-Diversification

Sale to an individual


11/25

Private firms are generally not rated and do not have bonds outstanding.Consequently to estimate the cost of debt one of the following approaches maybe used.

Basic Issue

Solutions

Cost of debt for private firm= cost of debt for similar firms(in terms of size) in theindustry. Used for firms being valued for an IPO.

Cost of debt=Interest rate on recent borrowings. Used when the private firm hasborrowed money recently.

Based on synthetic rating using interest coverage ratios. Then compute thedefault spreads on these ratings to arrive at cost of debt.

Cost of debt


12/25

Estimating cost of capital

The debt ratios are mostly stated in book value terms rather than marketvalues. There is also a chance that the debt ratio may change for a privatefirm that is planning to go public.

Basic Issue

Solutions/Assumptions

Debt Ratio of private firm= Industry Average Debt Ratio

Debt Ratio of private firm=Optimal Debt Ratio

It is important that the debt ratio assumption must be consistentwhile calculating Beta, debt ratings and Cost of Capital

Estimate the Debt Ratio of private firm based on circular reasoning. Startwith the book debt and cost of capital->estimate the firm and equity value-

>use these values to arrive at a new debt ratio and cost of capital and re-estimate the firm and equity value. Continue till the debt and equity valuesconverge in the cost of capital computation.


13/25

Estimating cash flows

Problems

Solutions/Assumptions

Restate the earnings using consistent accounting standards

Exclude any expenses that may be personal while computing income

Estimate a reasonable salary based on the services rendered by the owner to

the firm

Intermingling of personal and business expenses.

Thin line between salary and dividends.

Effect of taxes on value since individual tax rates and corporate tax rates differ

Different accounting practices are followed across different private firms.


14/25

The expected growth rate in operating income is the product of reinvestment rateand the return on capital.

Historical growth

Fundamentals (Reinvestment rate and Return onCapital )

The shifting accounting practices may reflect the reported earnings are notrepresentative of actual earnings. Also most private firms are young and there maybe lack of historical data

Persistence of growth

The infinite life concept needs to be considered with more caution since the

transition from one owner to another need not be smooth. Implications on the valueof growth1. Terminal value of private firm is less than the terminal value of a publicly tradedfirm. If the owner retires- we may use the liquidation value as terminal value2. If the owner plans for transition, the value of the business is more than the firmthat doesnt have transition plans chalked out.

3. Private firms that are becoming larger even in terms of management, resemblepublicly traded firms, and for these we may assume infinite growth

Estimating growth rate


15/25

Comparable Company Trading Multiple Analysis (Comps)

Select the comparable companiesCalculate relevant financials and multiplesApply valuation and analyze the resultsApply a private company discount

Comparable Transaction Analysis (Transaction Comps)

Use of actual transaction multiples instead of trading multiplesIndustry, timing (recent), geographic location, size etc.Data could be difficult to locate

Drawbacks

Not all aspects are captured in multiplesUnavailability of metrics other than salesFinding comparable companies and deals may not always be easyPrivately owned companies are less desirable

Relative Valuation techniques


16/25

Asset AppraisalCompanies with heavy fixed assetsFair market value of fixed assets and equipment is calculated as a means ofevaluating the business.

Break-up AnalysisA sum of parts valuation based on different business linesRelevant for private companies with dissimilar business lines

Replacement CostConsiders total cost of reproducing operations of the business in todaysenvironmentStart-up expenses, real estate, equipment, and inventory and labor costs

LBO AnalysisTo determine range of prices a financial buyer would be willing to pay based ontarget ROE (IRRs) and leveraged capital structure.

Internal Rate of ReturnUsed to calculate the entry price, exit price, or average cash flows in aninvestment.Given certain inputs such as exit price and cash flows within the investment,

can be used to calculate a desired return rate, entry price, or other factors.

Other commonly used techniques


17/25

Value for control premium to acquire a block of equity

Probability that control of the firm will change.

Value of gaining control of the company = PV(Value of company with change incontrol-Value of company without change in control) + Side benefits of control

Need to estimate the effects of creating different classes of shares in the IPO andthe effects of the options or warrants on the issuance price per share.

In case of an IPO

Class of shares having voting rights more valuable than the ones without votingrights.

Difference should be the function of the value of controlling the firm

Other Adjustments


18/25

Factors determining illiquidity discount

Size of the firm Larger the firm , smaller the liquiditydiscount

Health of the firm Healthier firms->Lower liquidity discount

Type of assets owned by the firm More the liquid the asset, lower theliquidity discount for the firm

Cash flow generating capacity Generating large amounts of cash->smaller discounts

Size of the block The liquidity discount should increase

with the size of the portion being sold.

Investments which are more liquid must be traded at a higher price than those thatare less liquid investments.

No illiquidity discount if sale is being made to a public company

Effects of illiquidity on value

O


19/25

Preference for Acquisitions:

Strong competition in the product market

Better valuation of the firm by potential acquirers by virtue of their industry

expertise unlike atomistic investors in the IPO market, who can be expected to

be at an informational disadvantage with respect to firm insiders

Preference for IPOs:

Acquirers can have considerable bargaining power, allowing them to extract

the firms net present value (NPV) from insiders

Entrepreneur may derive personal benefits from continuing to manage it long

term (private benefits of control), which he would lose after an acquisition

IPO vs Acquisitions

E i d ???


20/25

Retention of benefits v/s immediate cash flows

Entrepreneur may be biased towards exiting via an IPO due to retention of

private benefits of control whereas the VC may decide based on financial

considerations (cash flow benefits) alone.

Long term v/s short term investor

Entrepreneur is typically a long-term investor planning to continue much of his

pre-exit equity stake in the firm even after an IPO listing whereas the VC may

often be a short-term investor planning to liquidate much of his pre-exit stake

soon after the IPO.

Exit conundrum???

Disagreement between entrepreneur and VC on the preferred means ofexit in equilibrium

O l d / d l d IPOS


21/25

20

25

30

35

40

45

Facebook Stock price

140

160

180

200

220

240

Speciality RestaurantsStock price

Reasons of Overvaluation:Pricing and not valuation Incorrect underlyingassumptions Willing to pay control premium

Restricted stock studies

Price Band : 34-38 $Issue Size : $104 billion

Price Band : 146-165 Rs.Issue Size: Rs. 171.4 - 182.0 Cr.

Reasons of Undervaluation:Excess reliance on Mainland China

brand name Difficulty in recouping certain capitalimprovement costs

Volatility in earningsInability to accurately forecast

Overvalued v/s undervalued IPOS

Ch i V l i h i b d i


22/25

Valuation for sale to

a private entity

Valuation for sale to

a publicly traded firmor an IPO

Cost of Equity Based on Total Beta Based on market betasince owner is diversified

Cost of debt May reflect additionalspread since it isassociated with being aprivate business

Based upon syntheticratings, obtained bylooking at comparablepublicly traded firms

Operating Cash Flows Tax rate should be usedof private business

Corporate marginal taxesmust be used

Firm life Finite life terminal valueor liquidation value

Perpetual value

Illiquidity discount Should be discounted No illiquidity discount

Change in Valuation techniques based on motive


23/25

Approach

Respondents

DDM1 DCF2 EVA3 APV4 Other(LBO)

DependentAdvisors

45.5 100.0 45.5 9.1 9.1

IndependentAdvisors

14.3 85.7 7.1 0.0 21.4

PrivateEquity

0.0 78.6 14.3 0.0 57.1

Total 17.3 87.2 20.5 2.6 30.8

Notes: 1. DCF = Discounted cashflow model2. DDM = Dividend discount model3. EVA = Economic value added4. APV = Adjusted present valuex2 of equal use of present value approaches: p-value = 0.001Fisher's Exact test of equal use of present value approaches across the three groups of participants (dependent =independent = private

equity) = 52.03, p-value = 0.002Source: Issues in Valuation of Privately Held Firms by CHRISTIAN PETERSEN, THOMAS PLENBORG, AND FINN SCH0LER

Present value approaches for valuation


24/25

Respondents 1 year 1 5 years 68 years 9-12 years + 12 yearsAverage(years)

Dependent 0.0% 46.2% 33.3% 23.1% 0.0% 6.1

Independent 0.0% 27.3% 36.4% 36.4% 0.0% 7.2

Privateequity 0.0% 64.3% 21.4% 7.1% 0.0% 4.2

Total 0.0% 42.9% 42.9% 14.3% 0.0% 5.8

Average forecasting horizon

One consequence of using a short forecasting period is a significant under-valuationof a firm, or it requires heroic long-term growth assumptions.The value of a small business often depends on the presence of the owner. As soonas he/she retires, the firm's most valuable asset disappears.

The intermingling of business and private expenses is particularly problematicin small businesses This problem of lack of clarity in expense allocation is found to be positively

correlated with the level of ownership concentration.


25/25

Thank You

Group 2Akshayita SaxenaPrerna LotlikarRhea MainiSai Sunil

Bhrugumalla

Group02 Valuing Private Businesses

Documents

Transcript of Group02 Valuing Private Businesses