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.