Changes in the U.S. equity capital markets during the past several years have caused significant shifts in shareholder value for both publicly and closely held companies. While shareholders of public companies can easily measure the magnitude of these changes, their impact on the value of closely held firms is less clear.
The management teams of many closely held concerns have looked to the professional judgment of independent investment and financial advisors to establish their companies’ fair market values. Here are key factors these experts consider in their determinations, followed by profiles of three primary valuation methods: discounted cash flow, comparative company and comparative transaction analyses.
Fair and Square
An independent financial advisor assessing value typically has one primary objective: to determine the price a willing buyer would pay a willing seller in an arm’s-length transaction in which both parties know the relevant facts. In the absence of a liquid public market – in which value is determined by current supply and demand factors – analytical techniques can effectively determine fair market value.
Investors, financial analysts, corporations and regulators examine many variables in evaluating fair market value. Some relevant factors include:
- Size of the markets and potential growth for the company’s products or services,
- Breadth of products or services offered, as well as the diversity and stability of the company’s earnings base,
- Cost and availability of equipment, labor and other critical operational factors,
- Effect of government policy and regulation on firm revenues, net income and capital expenditure plans,
- Quality and depth of management,
- Quality and efficiency of operating facilities,
- The company’s financial condition, as well as its revenue growth rate and cash flow margins and its ability to manage ongoing capital requirements, and
- Overall condition of the economy, the industry and the capital markets, including how investors generally regard the industry as an investment medium.
The valuation process typically starts with extensive discussions with senior management. These meetings – critical to assessing the relative importance of various valuation considerations – provide a means of reviewing the company’s history, current operations, competitive position and likely future financial performance. A tour of key operating facilities also helps a third-party advisor fully understand the business and clarify the degree to which operations are capital intensive.
When valuing a private company’s equity securities, the advisor often determines the company’s total value (also known as enterprise value). He or she then deducts third-party security obligations, such as outstanding debt, from the enterprise value. The resulting amount is a company’s equity value.
From a quantitative standpoint, the financial advisor thoroughly analyzes historical and current financial information as well as internal financial forecasts. In addition, the advisor usually reviews industry data and comparative public company financial data obtained from independent sources.
Methods To Prevent Financial Madness
The valuation process incorporates several analytical methodologies commonly used to value private businesses. They include:
Discounted cash flow (DCF) method. The DCF approach projects the company’s cash flow as an ongoing entity and then discounts it back at an appropriate risk level to arrive at an aggregate present value.
The DCF method requires making reasonable financial projections about revenues, manufacturing and operating costs, working capital requirements, and capital expenditures to determine the amount available annually to distribute to shareholders or reinvest in the business. The third-party advisor then discounts these net cash flows back to a present value at a return rate that reflects the perceived degree of risk associated with achieving the results, based on macroeconomic, industry and company-specific factors.
The DCF analysis calculates an enterprise or total company value – unless the financial projections specifically include financing-related costs (for example, interest expense) and third-party security obligations such as debt repayment. If those financing-related cash flow requirements are factored into the projections, an appropriately applied DCF analysis provides the estimated equity valuation for the company.
The company’s DCF-derived value then reveals its going-concern value. This contrasts sharply with liquidation value, which represents only the amount of proceeds expected from an orderly sale of the company’s assets (land, building, inventories and the like). The DCF analysis implicitly assumes the company will continue operations.
Comparative company method. With this method, the advisor establishes the fair market value of a closely held company by examining the market prices and valuation multiples of similar public companies. Although identifying public companies that match exactly is sometimes difficult, investors must view each of the comparable companies similarly in their ongoing appraisals of relative investment values.
Thus, comparable companies generally should be subject to the same economic forces that affect the firm being valued in terms of operations, markets and government regulation. The resulting ranges of price/earnings multiples, cash flow multiples and market-to-book values for the comparable group represent minority interest valuations.
Some companies have several unrelated businesses, making comparability more complex. Then selecting a different set of comparables for each operation may be appropriate. Using this approach, a financial advisor establishes separate values for each business segment based on its individual earnings, cash-generating ability and investment risk.
Comparable transactions method. This method examines multiples similar to those used in the comparable company approach. However, the transactions method examines the prices paid and the related valuation multiples of control transactions (for example, sales and mergers) for companies similar to the subject company. The relevance of these comparison transactions depends on the extent of the similarities between the companies and their respective businesses.
Control vs. Minority Interest
The ownership level being valued has an important effect on the valuation of closely held company stock. Historically, investors have paid significant premiums to gain control of a company’s operations and cash flow. Thus, a valuation may reflect a “control” premium a third-party investor would likely pay if the ownership percentage being valued were greater than 50% and results in control over the company’s operations and financials.
In recent years, the average premium paid for control of publicly held companies has ranged from 30% to 50%. Of course, this premium varies by industry, reflecting the different risks and opportunities of the targeted business’s products and services. In some instances, strategic buyers have been willing to pay premiums significantly above marketplace norms. It’s important to note that the comparable transactions method already factors in these control premiums.
If the ownership level being valued represents less than half of the company’s voting power, the financial advisor may apply a discount that reflects the lack of cash flow control. Although comparative company market prices already reflect minority interest values, applying a discount to the going-concern value derived by projecting future cash flows may be appropriate – if the discount included financial benefits of a control buyer.
Another common valuation adjustment is to reflect the unique risks inherent in the securities of closely held concerns. Such securities usually aren’t considered marketable.
An efficient market for buying or selling closely held company stock doesn’t typically exist; thus, the stock is regarded as having poor liquidity (defined as one’s ability to buy or sell an asset quickly at a known price). Because most closely held companies don’t guarantee a market for their stock, an advisor will apply a discount to reflect the “lack of marketability risk” facing investors. This is especially true when valuing a minority interest position.
The Final Analysis
Determining the fair market value of a closely held company is a matter of judgment that considers all relevant quantitative and qualitative factors. The process requires a critical understanding of a company’s historical operating record and the unique risks and opportunities that a closely held company is likely to face in the years ahead. Please call us if you need assistance valuing a closely held business.