[EQUITY VALUATION] CFA II LOS 34: PRIVATE CO VALUATION

Because they are applied in a sequential process, the DLOC and DLOM are multiplicative, not additive. So if the DLOC is 20%, and the DLOM is 13%, the total discount is: total discount = 1 - [(1 - DLOC)(1 - DLOM)] total discount = 1 - [(1 - 0.20)(1 - 0.13)] = 30.4% This is not the 33% found when using an additive calculation.

back out control premium/DLOM if already in.

Expanded CAPM

calculate CAPM and then add small stock premium and company-specific premium unless otherwise told

Reasons for Private Valuation

transactions, compliance, and litigation

LOS 34.e: Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings.

In valuing a firm, the appropriate earnings definition is normalized earnings: "firm earnings if the firm were acquired." The adjustments required to arrive at normalized earnings are discussed in the following.

LOS 34.i: Calculate the value of a private company based on market approach methods and describe advantages and disadvantages of each method.

Market approaches to valuing private firms use price multiples and data from previous public and private transactions. The three methods discussed in the following are: 1. the guideline public company method (GPCM), 2. the guideline transactions method (GTM), and 3. the prior transaction method (PTM).

The Discount for Lack of Marketability

The DLOM varies with the following: - An impending IPO or firm sale would decrease the DLOM. - The payment of dividends would decrease the DLOM. - Earlier, higher payments (i.e., shorter duration) would decrease the DLOM. - Contractual restrictions on selling stock would increase the DLOM. - A greater pool of buyers would decrease the DLOM. - Greater risk and value uncertainty would increase the DLOM.

Guideline Public Co Method

The guideline public company method (GPCM) uses price multiples from trade data for public companies, with adjustments to the multiples to account for differences between the subject firm and the comparables. Although there are usually numerous public company transactions available, the data should be checked to see that they are comparable.

LOS 34.d: Explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach.

- Income approach: Values a firm as the present value of its expected future income. Such valuation may be based on a variety of different assumptions and variations. - Market approach: Values a firm using the price multiples based on recent sales of comparable assets. - Asset-based approach: Values a firm's assets minus its liabilities.

LOS 34.g: Explain factors that require adjustment when estimating the discount rate for private companies.

1. size premiums 2. availability & cost of debt 3. acquirer vs target 4. projection risk 5. lifecycle stage

Strategic & Nonstrategic Buyers

A transaction may be either strategic or financial (nonstrategic). In a strategic transaction, valuation of the firm is based in part on the perceived synergies with the acquirer's other assets. A financial transaction assumes no synergies, as when one firm buys another in a dissimilar industry.

Control Premiums

Control premium adjustments are made only to the equity portion of the firm's value. There are two ways to incorporate control premium under a guideline public company method: 1. Use the raw multiple to estimate firm value (without control premium) and estimate the equity portion (by subtracting debt). Apply the control premium to the equity portion as estimated. 2. Beginning with an equity control premium, we adjust this control premium for valuation using an MVIC multiple: adjusted control premium (applicable for MVIC multiple) = (control premium on equity) × (1 - DR)

EXAM FOCUS

For the exam, be familiar with differences between private and public companies and know the different definitions and approaches for value estimation. Be prepared to normalize earnings, determine an appropriate discount rate, and calculate private firm value using the income, market, and asset-based approaches. Know when and how discounts for control and marketability are applied.

Capitalized Cash Flow: Firm Valuation

If growth is non-constant, the capitalized cash flow method (CCM) should be avoided in favor of the free cash flow method. The CCM could be used to back out the discount rate or growth rate implicit in market data. Valuing the firm as a whole using the CCM:

Company & Stock-Specific Factors for Private Companies

Overall, company-specific factors can have positive or negative effects on private company valuations, whereas stock-specific factors are usually a negative. Compared to public companies, private companies have greater heterogeneity so that the appropriate discount rates and methods for valuing them vary widely as well.

LOS 34.f: Calculate the value of a private company using free cash flow, capitalized cash flow, and/or excess earnings methods.

The income approach refers to valuation methods based on the idea that the value of an asset is the present value of its future income. Three methods consistent with the income approach are: - the free cash flow method (a.k.a. discounted cash flow method), - the capitalized cash flow method, - and the residual income or excess earnings method.

Prior Transaction Method

The prior transaction method (PTM) uses transactions data from the stock of the actual subject company and is most appropriate when valuing minority (noncontrolling) interests. The valuation under this method can be based on the actual transaction price or multiples derived from such transactions. Ideally, the previous transactions would be arm's-length, of the same motivation (strategic or financial) as the subject transaction, and fairly recent.

Capitalized Cash Flow Equity Valuation

To estimate the value of the equity, the market value of the firm's debt is subtracted from firm value. Alternatively, the value of firm equity can be estimated by discounting the free cash flows to equity by the required return on equity (r):

The Excess Earnings Method

Under the excess earnings method, the analyst starts with the earnings that should be generated by working capital and fixed assets based on an estimate of the required return. Excess earnings are firm earnings minus the earnings required to provide the required rate of return on working capital and fixed assets. The value of intangible assets can be estimated as the present value of the (growing) stream of excess earnings (using the excess earnings and the growing perpetuity formula from the CCM). This value for the intangible assets is added to the values of working capital and fixed assets to arrive at firm value.

The Capitalized Cash Flow Method

Under this method, a single measure of economic benefit is divided by a capitalization rate to arrive at firm value, where the capitalization rate is the required rate of return minus a growth rate. This is a growing perpetuity model that assumes stable growth and is, in effect, a single-stage free cash flow model. It is most often used for small private companies.

Guideline Transactions Method

When using the guideline transactions method (GTM), prior acquisition values for entire (public and private) companies that already reflect any control premiums are used, so no additional adjustment for a controlling interest is necessary. Other items to consider: transaction type, contingent consideration, type of consideration, availability of data and date of data.