Private Company Valuation

Welcome to the World of Private Company Valuation!

In the Equity section of CFA Level II, we spend a lot of time talking about public companies like Apple or Coca-Cola. But what happens when you need to value a family-owned business, a tech startup, or a massive private conglomerate? That is what this chapter is all about! Private Company Valuation is vital for M&A (Mergers and Acquisitions), IPOs, and even for tax purposes. While the core principles of finance remain the same, valuing a private company requires some extra "detective work" and specific adjustments.

Don't worry if this seems a bit more "subjective" than public company valuation—by the end of these notes, you'll have a clear toolkit to tackle any private company problem the CFA exam throws at you!

1. Private vs. Public: What's the Difference?

Before we dive into the math, we need to understand the environment. Private companies differ from public ones in several key ways:

• Stage in Life Cycle: Private companies range from tiny startups to mature giants.
• Size: Generally smaller, which often means more risk and less access to capital.
• Information Quality: There is no SEC or regulator forcing them to publish perfect financial statements. Information is often less transparent.
• Liquidity: You can't sell a private business with a click of a button like you can with shares of Microsoft.
• Management/Ownership: Often, the owners are the managers. This can lead to "blurry" financial lines (like the owner's personal car being paid for by the company).

Standards of Value

In private valuation, "Value" depends on who is asking. Standard of value refers to the definition of value being used:

• Fair Market Value: The price a willing buyer and willing seller would agree upon (used mostly for tax purposes).
• Investment Value: The value to a specific buyer (includes synergies).
• Intrinsic Value: The "true" or "real" value based on fundamentals.

Quick Review: If a buyer thinks they can save money by merging the company with their own, they are looking at Investment Value, not Fair Market Value.

2. Normalizing Financial Statements

Because owners of private companies often run personal expenses through the business or pay themselves "special" salaries, we have to normalize the accounts. Think of this as "cleaning the windows" so you can see the true profit clearly.

Common Adjustments:

• Officer Compensation: If the owner pays themselves $500,000 but a professional manager would do the job for $200,000, we add that $300,000 difference back to the profit.
• Non-recurring Items: Remove one-time legal fees or storm damage costs.
• Personal Expenses: If the company pays for the owner’s family vacation, add that back!
• Real Estate: If the company owns its building, we sometimes separate the real estate from the business operations.

Step-by-Step Normalization:
1. Start with reported EBITDA.
2. Add back personal/excessive expenses.
3. Subtract any under-reported expenses (like if the owner isn't taking a salary at all).
4. The result is Normalized EBITDA.

Key Takeaway: We normalize to find out what the business would earn if it were run by a neutral third party.

3. The Income Approach

This approach values a company based on the present value of its future expected income. There are two main methods you need to know:

A. Free Cash Flow Method (DCF)

Just like with public companies, we project FCFF (Free Cash Flow to the Firm) or FCFE (Free Cash Flow to Equity) and discount them back. However, for private firms, we often use a higher discount rate because of the extra risk.

B. Capitalized Cash Flow Method (CCM)

We use this when the company is stable and growing at a constant rate. It’s basically the Gordon Growth Model!
\( V_0 = \frac{FCF_1}{r - g} \)

The "Build-Up" Method for Discount Rates

Since we can't easily calculate "Beta" for a private company (there's no stock price to track!), we often build the discount rate from scratch:

Required Return = Risk-free rate + Equity risk premium + Size premium + Specific company risk premium

Did you know? The "Size Premium" is added because smaller companies historically have higher risks and higher returns than large-cap stocks.

Quick Review: In the build-up method, we do not usually multiply by Beta because we are adding specific risk premiums instead of using the CAPM framework directly.

4. The Market Approach

This is the "real estate agent" approach: "What did the house next door sell for?" There are three main methods here:

• Guideline Public Company Method (GPCM): Look at similar public companies. Use their multiples (like EV/EBITDA), but then apply a discount because the private company is harder to sell (lack of marketability).
• Guideline Transaction Method (GTM): Look at actual acquisitions of similar private or public companies. This is great because the prices already include a "control premium."
• Prior Transaction Method (PTM): Look at previous sales of shares in the same company. This is the most relevant evidence if the transaction was recent and arm's length.

Common Mistake: Using a public company multiple for a tiny private business without adjusting for risk or growth. Always look for the "closest" match!

5. The Asset-Based Approach

This method values the company as the sum of its parts (Assets minus Liabilities). This is usually the "method of last resort" for profitable, going-concern businesses, but it is perfect for:

• Liquidation scenarios.
• Investment companies (like a holding company that just owns real estate or stocks).
• Very small businesses with no "brand" or "goodwill" (like a single-truck hauling business).

Key Takeaway: For a successful software company, the Asset-Based approach will usually give you a value that is too low because it misses the value of future growth and human capital.

6. Valuation Adjustments (The "Final Polish")

Once you get a "base value" for a company, you usually need to apply Discounts or Premiums. This is a high-probability exam topic!

Control Premium

If you are buying the whole company, you can make decisions (fire the manager, change strategy). This "power" is worth more. You pay a Control Premium.

Discount for Lack of Control (DLOC)

If you are only buying a 10% stake, you have no power. Therefore, the shares are worth less.
\( DLOC = 1 - [1 / (1 + \text{Control Premium})] \)

Discount for Lack of Marketability (DLOM)

Private shares are hard to sell. It might take 6 months to find a buyer. Investors demand a discount for this "stuck" capital.

Calculating the Total Discount

Important! You cannot just add DLOC and DLOM together. You must apply them multiplicatively.
Total Discount = \( 1 - [(1 - DLOC) \times (1 - DLOM)] \)

Example: If DLOC is 10% and DLOM is 20%:
Total Discount = \( 1 - [(0.90) \times (0.80)] = 1 - 0.72 = 28\% \). (Not 30%!)

Memory Aid: Think of discounts like "sales" at a store. If a shirt is 10% off and then you have a 20% coupon, the shop takes 10% off first, and then 20% off the new lower price.

Summary Checklist for Success

• Standard of Value: Always check if you are valuing for a specific buyer (Investment Value) or a general one (Fair Market Value).
• Normalization: Always check for owner’s salary or personal expenses before doing a DCF.
• Multiples: If using GTM (transactions), a control premium is already inside the number. If using GPCM (public peers), you might need to add a control premium.
• The Math: Practice the multiplicative discount formula—it's an easy place to lose points!

Final Encouragement: You've made it through the trickiest parts of Private Company Valuation! It’s all about adjusting the data to reflect the reality of a private business. Keep practicing those discount formulas, and you'll be a pro in no time!