Understanding Private Equity Valuation Methods

Private equity valuation methods can be complex, but they're essential for determining the worth of a company.

Discounted Cash Flow (DCF) analysis is a common method used in private equity valuation.

This method estimates the present value of a company's future cash flows, assuming a specific discount rate.

A key factor in DCF analysis is the choice of discount rate, which can significantly impact the final valuation.

The Weighted Average Cost of Capital (WACC) is often used as the discount rate in DCF analysis.

WACC is a company's average cost of capital, calculated by weighing the cost of debt and equity.

The cost of debt is typically lower than the cost of equity, so WACC tends to be lower than the cost of equity.

Private equity firms often use a risk premium to adjust the WACC for the company's specific risk profile.

The risk premium can range from 3% to 10% or more, depending on the company's industry and other factors.

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The Enterprise Value (EV) method is another private equity valuation method that calculates a company's value by adding debt and subtracting cash.

This method is often used to value companies with significant debt or cash holdings.

The EV method is particularly useful for companies with complex capital structures.

A company's EV can be calculated by adding its market capitalization, debt, and other liabilities, and then subtracting its cash and other assets.

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The Discounted Cash Flow (DCF) method is a widely used valuation technique for private companies. It estimates a company's worth by projecting its future cash flows and using the Net Present Value (NPV) method.

The DCF technique is theoretically sound because a company's worth comes from the value of its projected future cash flows. Academics, corporate finance experts, and other professionals use DCF.

However, the valuation depends on assumptions and forecasts, which can be flawed. If one assumption is incorrect, the valuation can be very different. This is often referred to as the "Garbage in = Garbage out" problem.

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To mitigate this issue, it's advised to combine DCF with other methods for accurate results. This can provide a "sanity check" on valuation outputs by incorporating market-related valuation data.

Here are some key considerations when using DCF:

By considering these factors and using DCF in conjunction with other valuation methods, you can arrive at a more accurate estimate of a private company's value.

The Multiples Method is a common way to value private companies, especially those with a proven track record of profitability.

A multiple is simply a ratio that compares a company's value to its earnings before interest, taxes, depreciation, and amortization (EBITDA). The majority of businesses generating between $10 million and $75 million of annual revenue historically transact for EBITDA multiples between 5.0x and 8.0x EBITDA.

The appropriate EBITDA multiple in calculating Enterprise Value is influenced by numerous factors, including level of customer concentration, company and industry growth rates, supplier concentration, competitive position, profit margins, size of the company, and depth and strength of the management team.

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A potential buyer will also want to gauge management's estimate of capital expenditures required for supporting growth of the business on a go-forward basis. Companies with little customer concentration participating in attractive end markets with high growth rates, such as medical or aerospace, or utilizing unique materials or processes, typically command higher than average EBITDA multiples.

In the case of a buyout situation, the PE company buys the investee company in 2023 for $600 in equity, with a net debt load of $730. It expects a rise in Enterprise Value (EPV) from $1330 to $1980 by means of improvements in both profitability (EBITDA going from $160 to $210) and the valuation of that profitability.

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Prior Transactions Analysis is a valuable method in private equity valuation. It involves examining past prices of comparable companies to determine the worth of a current deal.

This approach is also known as M&A Comps and is used to estimate the implied stock price in case of an acquisition. The analysis gives the acquisition price at closing, not the current value.

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PTA uses the buyer's price for a business to value it, considering the control premium. The control premium is the value of owning the entire company.

PTA usually has a higher valuation than other methods because it takes into account the value of control.

Precedent Transactions for Private Companies are similar to PTA, but with some key differences. There's no need to apply an illiquidity or private company discount because these prices reflect the acquisitions of entire companies.

Individual share purchases are what apply to the concept of liquid vs. illiquidity, not entire companies. Most sets of precedent transactions include a mix of private and public sellers, so adjustments might be over-compensated.

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Financial Statement Analysis is crucial when valuing a company, especially in private equity. A correct version of financial statements is essential, following IFRS, U.S. GAAP, or local GAAP, and proper classification of revenue and expense line items.

Small-business owners often create non-standard financial statements to plan effectively, but these statements can be misleading. For instance, they might deduct personal expenses as business expenses or list compensation as a "dividend" on the Cash Flow Statement.

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When analyzing financial statements, look for red flags such as intermingled personal and business expenses, taxes, and non-standard categories like "Net Sales" instead of "Gross Sales." These issues can lead to inaccurate valuations.

To create a standardized set of statements, identify and separate personal and business expenses, and ensure proper tax classification. This will provide a more accurate picture of the company's financial performance.

In some cases, private equity companies may benefit from integrated value calculation, which considers both financial and social value. However, this can be costly and may not always be necessary, especially in smaller deals.

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S and E, or Sales and Expenses, have a significant impact on the financial value of a company, just like in public equity. In private equity, S and E affect the valuation of F, or Financial performance, through value drivers like sales growth, EBIT margin, and cost of capital.

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Calculating integrated value in private equity is similar to public equity, but it's often not necessary, especially for smaller deals. Academic evidence shows that on average, the exploitation of E and S by PE does not happen, so calculating integrated value makes most sense in larger deals with serious doubts about the overall value creation pattern.

Private equity companies, or PE companies, come in several types, with different goals and methods. Some PE companies, like 3G Capital, are known for their aggressive cost-cutting strategies, which can have a significant impact on a company's financial performance.

PE has a reputation for making companies more profitable, but the evidence is mixed. Research by Manigart et al. (2022) found that, after buyout, PE-backed companies experience higher growth than similar non-PE-backed companies, especially in the twenty-first century.

Here are the three sources of value creation identified by Kaplan and Strömberg (2009):

Enterprise Value and Shareholders Value are two distinct financial metrics that often get confused with each other.

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Enterprise Value is a realistic estimate of a company's worth, calculated by multiplying EBITDA by an appropriate multiple. This method provides a cash-free and debt-free basis for valuation.

Shareholders Value, on the other hand, takes into account a company's cash and cash equivalents, minus its third-party debt. It's calculated by adding Enterprise Value to cash and subtracting debt.

Businesses typically transact on a cash-free, debt-free basis, which means Enterprise Value is a more accurate representation of the company's value in these situations.

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Private equity fund structure is a complex system, but it's essential to understand for financial statement analysis. A PE company raises and advises a PE fund through two entities: the General Partner (GP) and the investment manager.

The General Partner is responsible for managing the PE fund and has a fiduciary duty to act in the sole interest of the fund's investors. They issue capital and make investments while respecting the Limited Partnership Agreement (LPA).

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The LPA sets out the mandate of the fund and may delegate some management functions to the investment manager of the PE company's investment committee. GPs have skin in the game with an equity stake of 1-10% of the fund.

Private equity companies are typically organized as a partnership or limited liability corporation. The larger PE companies, such as Blackstone, Carlyle, and KKR, are mainly active in buyouts.

Fees are typically paid in a '2 and 20' structure: a 1.5-2% management fee and 20% carried interest, which is the percentage of profits paid to the GP.

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In addition to the Enterprise Value method, there are other common valuation methods used for private companies. These include the Asset Based, Discounted Cash Flow, and Market Value methods.

The Asset Based Valuation Method examines a company's balance sheet, subtracting total liabilities from total net asset value. This approach can be broken down into two methods:

The Market Value Valuation Method compares a business to similar companies, ideally using financial information from precedent transactions to arrive at an accurate valuation. However, this method fails to take into account differences in capabilities, projected growth rates, intangible assets, and other relevant factors.

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Private valuation methodologies differ from public ones in a significant way. Liquid funds are valued based on observable market prices, while private equity investments must use a variety of inputs to derive a fair market value.

Publicly traded companies have their valuations driven by market prices, which can be influenced by both fundamentals and investor sentiment. This is different from private equity investments, which rely on three common approaches: publicly traded comps, transaction comps, and discounted cash flow models.

The public comp method involves taking observed valuation metrics of comparable publicly listed companies and applying them to the earnings of a private company. This approach is rooted in fundamentals, rather than market sentiment.

Transaction comps use the purchase price multiples of recent private transactions of similar companies to derive a valuation. This method also focuses on fundamentals, rather than market trends or recent news.

Discounted cash flow models project future earnings for a company and apply a discount rate to calculate a present value. In most cases, managers use some type of weighted average of these three methodologies to value their companies.

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Asset Based Valuation is one of the approaches used in this method, which examines a company's balance sheet to determine its value.

To calculate the value, total liabilities are subtracted from the company's total net asset value. This method can be broken down into two approaches: one that values assets at their historical cost and another that values them at their current market value.

Some business owners may rely on the Discounted Cash Flow (DCF) Valuation Method, which evaluates a company based on its projected cash flow over time, adjusted to present value using a realistic discount rate.

This method is considered advantageous because it evaluates companies on an absolute basis, removing subjectivity from the valuation process.

The Market Value Valuation Method compares a business to similar companies, but it's essential to note that this method fails to take into account differences in capabilities, projected growth rates, intangible assets, and other relevant factors.

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A word of caution: using industry average market capitalization data from public companies can be misleading, as it doesn't account for unique differences between companies.

Here are the main valuation methods mentioned, along with their key characteristics: