How to Value a Private Company
Merger & Acquisition Series
Valuing a private company is an important and often elusive
process. Because there is no exchange to
determine market value, each transaction must be evaluated on its own
merit. Ultimately, the value is what a
seller is willing to accept and a buyer is willing to pay. No matter which side of the transaction you
are own, however, it helps to take a methodically approach. At Geo Strategy Partners we use the following
five methods:
1.
Discounted Cash Flow Method (DCF) or the Present
Value of Future Earnings.
2.
Market Value or the price paid for transactions
involving similar companies.
3.
Book Value or the Net of Assets and Liabilities
(typically plant and equipment items are adjusted from depreciated to
replacement value).
4.
Strategic Value or the specific value to a
buyers’ overall business. This method requires a bit of research and analysis
and must be custom developed for each potential buyer and seller in a potential
transaction.
5.
Competitive Process. This method applies to the
sell side and usually requires an M&A intermediary (investment banker,
broker, or business consultant) to create a competitive bidding process among a
number of suitors.
In this posting, I will address the most common - and probably
the most reliable – Discounted Cash Flow.
·
DCF (Discounted Cash Flow)= the present value of
future earnings.
o I
believe this is the most accurate; but how good it is depends on the accuracy
of the assumptions underlying the forecast
o The
most important assumptions support the projection of an income statement;
typically for five years into the future.
o Revenue,
COGS (Cost of Goods Sold), G&A (General & Administrative or Overhead),
and EBITDA (Earnings Before Interests, Taxes, Depreciation, and Amortization)
must all be projected. Other methods are
based on free cash flow which is a little more complicated since you must take
into consideration taxes and similar cash expenses.
o Projecting
the trend line of historic income statements is the place to start if you have
a three to five year history of relatively stable performance. The assumption is simply that business will
continue to grow in the future at the same CAGR as the past.
o The
next component to factor in is the firm (booked) backlog of business. Revenue under contract obviously
substantiates a projected trend line and, if robust, can justify increasing the
steepness of the top line revenue curve.
o The
sales pipeline should be considered next.
This is best projected utilizing a weighted average of outstanding
proposals, business development underway, prospects, and leads. Each component should be weighted based on
the likelihood of it being becoming real business. For example outstanding proposals might have
a 50% likelihood of becoming booked business and would be weighted as such;
business development activities underway should represent a fairly large amount
of potential revenue but perhaps experience shows that about 25% will become
real business. In this case the total
potential business you are actively pursuing would be given a weight of 25% of
the total value. Prospects and leads
might be weighted as low as 5 or 10%.
o As
always, the more the assumptions underlying these projections are documented
and supported, the more reliable they are assumed to be.
o New
business opportunities can also be included.
These could represent new markets to be pursued or new products planned
for introduction. If there is work
underway to realize these opportunities or solid research to support how they
might come about, it is perfectly legitimate to factor them in under a weighted
formula.
o COGS
and other expenses must be factored based on what will be required to realize
the projected revenue. If additional
capital expenditures are required, this factor will have to be accounted for in
the overall evaluation but should not be included in the forecast itself except
as a footnote.
o Next,
you need to adjust this pro forma income statement for factors that will change
after a transaction. This is known as
recasting earnings.
o For
example, if the owner of a company is the CEO and will not stay on after the
acquisition, his salary, benefits, and related costs can be added back in. An accounting system or even an entire
accounting department can sometimes be eliminated because it becomes
redundant. These costs can also be added
back. On the other side of the ledger, there
are sometimes new expenses that must be incurred as a result of a merger or
acquisition, and these should be subtracted from the forecast.
o Once
you have a well-documented and recast pro
forma income statement, you have the basis for a DCF analysis.
o EBITDA
or net profit before interest, taxes, depreciation, or amortization then becomes
the basis for the DCF analysis.
o The
five year earnings should be discounted back to their present value using the
basic formula for present value which is as follows (Excel has a function that
will do this for you):
o In
this formula, CF is EBITDA, the numeral is the year (i.e. year one projection;
year two projection, etc.); R represents the discount rate.
o Determining
the discount rate, is a critical, and often disputed, key variable in a DCF
valuation. It represents the time value
of money and is usually derived by first determining a risk free rate of return
that could easily be earned on a cash investment. A common place to start is
with a LIBOR rate or a 5 or 10 year U.S. Treasury Bond. The expected return on any instrument that is
considered virtually risk free, can be utilized but should be referenced in the
analysis. Next, we must adjust for
inflation. A reliable economic forecast
should be referenced in determining a projected average annual inflation rate
for the period of the forecast.
o Next,
we get to the most subjective component of the discount rate – the “Risk
Premium.” Because investing in a private
company is inherently more risky that the “risk free” investment alternatives,
we must factor in a premium to discount the value of future earnings to the
present day. Philosophically, it is
similar to the weighted average that we apply to backlogs and sales
pipeline. But it is actually more of a
factor that considers the likelihood that the company will not be able to
achieve the expected performance or meet the numbers projected in the pro forma. One risk factor is changing economic and
market conditions. Others relate to the
company itself and how stable it is perceived to be. It is the most subjective component of the
discount rate and subject to dispute between buyer and seller.
o An
example of how a discount rate might be derived is as follows:
*company
stability, exchange rate risk, industry and market risk, economic uncertainty,
risk that intellectual property can become obsolete, stability of companies
customers, threat of competition, etc.
o Once
this formula is computed we have the Present Value of Future Earnings or a
value for the company. But we are not
done.
o Assuming
our projection is for a five year period, what about year six and beyond? We also need to consider the value of the
earnings that continue to accrue to the buyer beyond the forecast period. We account for this by determining a
“Residual Value.”
o A
residual value or “salvage value” represents the what the company is projected
to be worth in year six, considering all the earnings that are expected in year
six and every year after that for perpetuity.
Obviously, the further out the earnings are received, the less their
present value until at some point they become negligible. There is actually a mathematical formula for
this, but we must also consider that no business can be expected to continue
forever in its present configuration.
So, how to we determine the value of the company in year six?
o Here
we have some risk of circular logic and sometimes the perception that we are
counting the value of a company twice; however, we need to account for the
value of earnings beyond the projected period.
There are two simple ways to do this:
Projected Book Value (explained in a later blog) or projected market
value (also explained in a later blog).
A short cut to market value is often a multiple of forecast earnings in
the last year of the projection. A conservative
multiple that is often used is 5 times EBITDA.
Since we are talking about earnings that might occur 5 years in the
future, we should be conservative. So if
our forecast projects EBITDA in year Five to be $1,000,000, the Residual Value
in year six is $5,000,000 or 5 x EBITDA.
This calculation is sometimes referred to as a “Hypothetical Sale.”
o But
this Hypothetical Sale value in year six must also be brought back to present
value using the same discount rate.
o Now
we add the present value of earnings for the forecast period plus the present
value of residual value and we have a value for the company using the
Discounted Cash Flow method.
o But
we may still need to adjust for other factors such as excess inventory, or
fixed assets that might have a useful life beyond the forecast period. However, by including a residual value in our
calculations, we have usually accounted for these factors since we are
projecting numbers so far into the future, it is unlikely that the effect of
such items will still be relevant.
The Discounted Cash Flow method is considered reliable
because the true value of a business is the profits it can make for the
shareholders. The formula itself is
solid math. The devil, however, lies in
the details of the assumptions.
Mark Towery
Managing Director
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