Determining the value of a public company is relatively straightforward. That is primarily due to the vast amount of publicly available information. Some analysts may provide these valuations for free to the general public. However, the same does not apply to private companies. Determining the value of a private company is a complicated process.
What is a Private Company?
A private company is a company that has limited or closed ownership. The shares of these companies are not available in the stock market. However, that does not mean that others cannot buy the company’s shares. Private company stockholders may trade their shares to other existing or new stockholders. However, attracting new stockholders is not as straightforward.
With public companies, the value of shares is available through the stock market. However, new investors may be reluctant to invest in private companies. Usually, private company shares are less liquid compared to public-listed companies. It introduces many challenges for private companies when it comes to obtaining finance.
How to value a Private Company?
The information that investors use to value a public company may not be available for private companies. Therefore, the traditional methods of company valuation are not applicable to private companies. Hence, investors will have to use other methods for valuing private companies. There are various approaches to do so, two of which are as below.
Comparable Company Analysis or Market Approach
With the market approach, investors can use a comparable company analysis (CCA) to value a private company. With this approach, investors identify public companies in the same industry as the company under consideration. Usually, the closer in growth, size, and age the public-listed companies are to the private company, the better it is.
With the market approach, investors can determine a close estimate of the private company’s value. Once investors calculate the price and cash flow metrics for the comparable companies, they can use it to calculate the subject company’s estimates. They can also calculate the EBITDA multiple for the subject company and use it to calculate its enterprise value.
Investors may also use comparative information from recent IPOs of other companies of similar size for this calculation. However, there are various problems with using comparable company analysis to do so. The primary issue with this approach is the research that investors must perform. Finding companies of similar size may not be possible.
Present Value Approach
The present value method is similar to public companies. Investors can estimate a private company’s value based on the present value of its forecasted cash flows. However, this approach also requires investors to make estimations about a company’s future cash flows. Once they obtain the relevant information, they must calculate the discount rate to determine the present value of cash flows.
The primary source of calculating a private company’s value under this approach is using its revenues. After an investor establishes a revenue growth rate, they can make forecasts about its future performances. Using this information, they can calculate a company’s free cash flows, which they can then use with Discounted Cash Flow (DCF) method.
Investors need to perform various estimations based on which they can calculate the private company’s value. These estimations can significantly alter a company’s value. Therefore, it is crucial for investors to perform accurate calculations and forecasts.
Due to the lack of information available for private companies, investors may find it difficult to determine their value. Private companies represent a closed ownership structure for which investors can’t find shares in the public market. However, investors can still use several approaches to calculate their value, including the market and present value approaches.
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