Three Approaches to Valuing a Privately-Held Company

By: Doug Peterson

As seen in Financial Executives

The potential for rising taxes due to huge U.S. government budgetary deficits are prompting many owners of privately held companies to consider their options. Other owners have a need to value their businesses for the purpose of estate planning – potentially a target for tax code changes.

Before considering a transaction, it’s helpful to have a clear understanding of the three common methodologies used to value private businesses.

Income Approach values a business or asset based on its expected future cash flow. When determining the business enterprise value, expected future cash flow represents cash flow available to debt and equity holders.

Cash flow projections generally incorporate expectations of future revenue growth and operating profitability as well as capital expenditure needs, working capital requirements, taxes and depreciation estimates. Cash flow projections also consider a residual component or terminal value, which reflects the expected value of the business at the end of the projection period.

Cash flows expected in the future are worth less today because of the time value of money and the risks associated with achieving the projected cash flows in the future. Accordingly, their present value is calculated by means of discounting, using a rate of return or discount rate that reflects the time value of money and the appropriate degree of risk inherent in the underlying business.

Market Approach is based on a comparison of the subject company to similar companies with quoted prices in actively traded markets, or which were involved in recent transactions for which meaningful data is available.

Using the market price quotation or the transaction price to estimate the market value of the comparable companies, multiples of value relative to significant financial variables (i.e., earnings, operating cash flow, assets, etc.) are developed for each of the comparable companies. Valuation multiples are adjusted for differences in growth and profitability prospects as well as risks applicable to the subject company versus each comparable.

Cost Approach is based on the investment required to replace or reproduce the assets of a business using current prices for labor, materials and operating facilities – less depreciation for physical deterioration and functional and economic obsolescence. The cost approach requires estimation of the value of the subject company’s net working capital, machinery and equipment, real estate and intangible assets.

It essentially represents a valuation based on the sum of the parts of a business and generally does not reflect a going-concern value. Therefore, this approach is mainly appropriate for holding companies or highly capital-intensive businesses where the value of a controlling interest is being considered, given that the value can typically only be realized through sale of the various parts initiated by an owner with a controlling interest.

Valuation Discounts

Minority interest discount. In closely held companies, a majority owner can skew cash flows in such a way that the minority interest receives little or no income. Since minority owners have less control over cash flows and must rely on majority owners or boards of directors to act in their best interest, a valuation discount is often applied to reflect that lack of control disadvantage.

For closely held companies, the minority interest discount can be significant because of limited dividends and stock sales that are not efficiently priced. A related discount commonly seen applies to non-voting share classes.

Lack of marketability discount. Inability to readily sell an ownership position increases the owner’s exposure to changing market conditions and increases the risk of ownership. Investors in privately held companies typically demand a higher return or yield in comparison to similar but publicly traded stocks.

Calculation of the discount for lack of marketability often relates to general economic and market conditions impacting the environment for merger and acquisition activity; qualitative factors of the subject interest affecting its marketability based on guidance provided in court cases; and observable discounts on restricted shares of publicly traded stocks and options.

Key man discount. A key man discount is applied if a business is dependent on one or a few key individuals, whose absence would materially affect operations.

Valuation Timetables

Third-party valuations of private businesses typically take about four weeks and include financial and organizational analysis, management interviews, industry and competitor reviews and often, onsite visits. Timeframes can often be accelerated when the quality of available information is high.