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2022 Curriculum CFA Program Level II Equity Investments

Private Company Valuation

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Introduction

The valuation of the equity of private companies is a major field of application for equity valuation. Private companies are those whose shares are not listed on public markets. Generalist investment practitioners need to be familiar with issues associated with valuations of such companies. We use the terms “valuation” and “appraisal” interchangeably in this chapter.

Many public companies have start-up or other operations that can best be valued as if they were private companies. Companies may grow through the acquisition of competitors, including private companies, and analysts must be prepared to evaluate the price paid in such transactions. Furthermore, acquisitions often result in significant balances of intangible assets, including goodwill, that are reported on the balance sheets of acquiring companies. Goodwill balances require impairment assessment or formal testing on an annual basis under International Financial Reporting Standards (IFRS) and US GAAP. Impairment testing and other financial reporting initiatives increasingly result in the use of fair value estimates in financial statements. The concepts and methods we will discuss play important roles in this aspect of financial reporting. In addition, issues relating to private company valuation arise in the types of investment held by venture capital and other types of private equity funds.

The following sections illustrate key elements associated with the valuation of private companies and provide background for understanding private company valuation, including typical contrasts between public and private companies and the major purposes for which private valuations are performed. Later sections discuss earnings normalization and cash flow estimation; introduce the three major approaches recognized in private company valuation, valuation discounts, and premiums; and explain business valuation standards and practices.

Learning Outcomes

The member should be able to:

  1. compare public and private company valuation;

  2. describe uses of private business valuation and explain applications of greatest concern to financial analysts;

  3. explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach;

  4. explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings;

  5. calculate the value of a private company using free cash flow, capitalized cash flow, and/or excess earnings methods;

  6. explain factors that require adjustment when estimating the discount rate for private companies;

  7. compare models used to estimate the required rate of return to private company equity (for example, the CAPM, the expanded CAPM, and the build-up approach);

  8. calculate the value of a private company based on market approach methods and describe advantages and disadvantages of each method;

  9. describe the asset-based approach to private company valuation;

  10. explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability.

Summary

We have provided an overview of key elements of private company valuation and contrasted public and private company valuations.

  • Company- and stock-specific factors may influence the selection of appropriate valuation methods and assumptions for private company valuations. Stock-specific factors may result in a lower value for an equity interest in a private company relative to a public company.

  • Company-specific factors in which private companies differ from public companies include:

    • stage in life cycle;

    • size;

    • overlap of shareholders and management;

    • quality/depth of management;

    • quality of financial and other information;

    • pressure from short-term investors; and

    • tax concerns.

  • Stock-specific factors that frequently affect the value of private companies include

    • liquidity of equity interests in business;

    • concentration of control; and

    • potential agreements restricting liquidity.

  • Private company valuations are typically performed for three different reasons: transactions, compliance (financial or tax reporting), or litigation. Acquisition-related valuation issues and financial reporting valuation issues are of greatest importance in assessing public companies.

  • Different definitions (standards) of value exist. The use of a valuation and key elements pertaining to the appraised company will help determine the appropriate definition. Key definitions of value include

    • fair market value;

    • market value;

    • fair value for financial reporting;

    • fair value in a litigation context;

    • investment value; and

    • intrinsic value.

  • Private company valuations may require adjustments to the income statement to develop estimates of the company’s normalized earnings. Adjustments may be required for non-recurring, non-economic, or other unusual items to eliminate anomalies and/or facilitate comparisons.

  • Within the income approach, the FCF method is frequently used to value larger, mature private companies. For smaller companies or in special situations, the capitalized cash flow method and residual income method may also be used.

  • Within the market approach, three methods are regularly used: the guideline public company method, guideline transactions method, and prior transactions method.

  • An asset-based approach is infrequently used in valuing private companies. This approach may be appropriate for companies that are worth more in liquidation than as going concerns. This approach is also applied for asset holding companies, very small companies, or companies formed recently that have limited operating histories.

  • Control and marketability issues are important and challenging elements in the valuation of private companies and equity interests therein.

  • If publicly traded companies are used as the basis for pricing multiple(s), control premiums may be appropriate in measuring the total equity value of a private company. Control premiums have also been used to estimate lack of control discounts.

  • Discounts for lack of control are used to convert a controlling interest value into a non-controlling equity interest value. Evidence of the adverse impact of the lack of control is an important consideration in assessing this discount.

  • Discounts for lack of marketability are often used in valuing non-controlling equity interests in private companies. A DLOM may be inappropriate if the company has a high likelihood of a liquidity event in the immediate future.

  • Quantification of DLOMs can be challenging because of limited data, differences in the interpretation of available data, and different interpretations of the lack of marketability’s effect on a private company.

  • DLOM can be estimated based on 1) private sales of restricted stock in public companies relative to their freely traded share price, 2) private sales of stock in companies prior to a subsequent IPO, and 3) the pricing of put options.