This is the second in a two-part article about strategies for a successful valuation. Last week, we talked about habits a business should develop from the start in order to get the most out of their valuation, and this week we’re talking about the differences between valuing public and private enterprises.
Both public and private companies have their perks. Public, as their name suggests, can tap into the lucrative financial markets. Case in point: Alibaba earned over $25 billion through its initial public offering, the largest in history, issued in September 2014. But to get those funds they need to regularly file a laundry list of paperwork, from quarterly earning reports to notices of insider stock sales and purchases.
Private companies, on the other hand, are free to go about their inner-workings without the close eyes of public shareholder scrutiny. But when it comes to business valuation, they often sell for 20 per cent less than public companies.
But why the discrepancy in value?
We sat down with Craig Maloney, a chartered accountant, chartered business valuator and partner at WBLI LLP sat down to explain the complexities between valuating private enterprises versus public enterprises.
Apples and oranges
“Typically, [both] are valued by considering the cash flow that is generated and applying a multiple to the cash flow based on the calculated risk of achieving the cash flow,” says Maloney.
While the access to earnings and cash flow within public companies is often easy to tap into, valuators need to dig in on private companies in a different way. The simplest method is a comparable company analysis an approach that requires taking a look at other businesses that closely resemble the one being valuated.
“Generally, a valuation of a public company will usually reference a market approach to valuation – for example, trading multiples on other similar public companies – as well as using other methods,” says Maloney. “Private companies are generally not determined using a market approach because they tend to be much smaller in size than their public counterparts.”
Trading multiples include things like operating margins, sales and free-cash-flow or equity valuation metrics like price-to-earnings, price-to-sales, price-to-book, and price-to-free cash flow.
Of course, to do this the business valuator will need to gather some financial information from the privately held company, but similarly sized competitors with comparable market share will often be valued closely.
Why do private companies sell for less?
One of the big elements is market liquidity, says Maloney.
“Public companies are priced by the market continuously (with public shares being) generally liquid assets that can be exchanged for cash very readily – ignoring closely held companies,” he says. “Whereas private companies are generally less liquid, as it takes time to sell private company shares.”
Maloney points out that discount rates or capitalization rates for public companies are often determined using a capital asset pricing model. Private company rates on the other hand tend to use a build-up method, which looks at a risk-free rate – the theoretical rate of return of an investment with zero risk – that Maloney says using the return for a long-term bond is approximately 2.5 per cent right now.
Then there’s a risk premium.
“The basket of stocks on the stock exchange – investors are looking for an additional return of about five to six per cent for equity investments,” he says.
Next is the industry-specific risk factor.
“For example, a waste management business has a lower risk factor than a startup technology business,” says Maloney.
Size and structure of the business also carries it own premium, which considers things like the size of the business (smaller companies are generally riskier than larger companies), reliance on a smaller number of customers and limited access to a strong management team.
Profitability also comes into play. While most public companies hinge their success on generating high profits to keep shareholders happy, private companies – which have fewer shareholders to impress – are more focused on reducing their taxes.
Sometimes this drifts into the realm of executive salaries, says Maloney.
“Some shareholders choose to pay a salary to themselves and close family members that is different from what they would pay an arm’s length party to fulfill the role,” he says, “For example, certain shareholders decide to pay themselves via dividend and do not draw a salary for their tax planning reasons, while other shareholders decide to draw a large salary or bonus.”
Business valuators must determine what the fair market salary would be for role and duty and adjust the income statement accordingly.
Maloney points to a scenario where the valuator has determined that the fair market salary for the role and duty of the owner-manager shareholder is $200,000. Suppose shareholder A is compensated with annual dividends of $200,000 and $0 salary.
“The valuator will have to adjust the historical cash flow of the business by deducting $200,000 each year to determine what a normal level of cash flow the business would generate,” says Maloney.
If shareholder B is compensated with $1 million of salary and bonus and $0 dividends, the valuator will have to adjust the historical cash flow of the business by adding $800,000 ($1 million less $200K) each year to determine what a normal level of cash flow the business would generate.
Get some help
Ultimately, says Maloney, both private and public business valuations are complex with many moving parts. Which is why it makes sense to enlist help.
“Chartered business valuators are respected and recognized as experts by the courts in cases involving financial matters, such as shareholder or partnership disputes, securities law, intellectual property disputes, family law, breach of contract, insurance claims, personal injury claims, amongst many others,” he says. “Whether it is in the context of mergers and acquisitions, succession planning, strategic planning, or reorganizations, CBVs are recognized as experts when it comes to business valuation.”