Analyzing Privately Held Companies

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Analyzing Privately Held Companies
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(No Transcript)
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Learning Objectives

• Primary learning objective Provide students with
  a knowledge of how to analyze and value privately
  held firms
• Secondary learning objectives Provide students
  with a knowledge of
• Challenges of valuing privately held firms
• Why and how private company financial statements
  may have to be recast and
• Adjusting the discount rate applied to private
  firm cash flows.

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Challenges of Valuing Privately Held Firms

• Lack of externally generated information
• Lack of adequate documentation of key intangible
  assets such as software, chemical formulae,
  recipes, etc.
• Lack of internal controls and rigorous reporting
  systems
• Firm specific problems
• Narrow product offering
• Lack of management depth
• Lack of leverage with customers and vendors
• Limited ability to finance future growth
• Common forms of manipulating reported income
• Revenue may be understated and expenses
  overstated to minimize tax liabilities
• The opposite may be true if the firm is for sale

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Adjusting the Income Statement

• Owner/officers salaries
• Benefits
• Travel and entertainment
• Auto expenses and personal life insurance
• Family members
• Rent or lease payments in excess of fair market
  value
• Professional service fees
• Depreciation expense
• Reserves

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Areas Commonly Understated

• When a business is being sold, the following
  expense categories are often understated by the
  seller
• The marketing and advertising expenditures
  required to support an aggressive revenue growth
  forecast
• Training sales forces to market new products
• Environmental clean-up
• Employee safety
• Pending litigation

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Areas Commonly Overlooked

• When a business is being sold, the following
  asset categories are often overlooked by the
  buyer as potential sources of value
• Customer lists
• Intellectual property
• Licenses
• Distributorship agreements
• Leases
• Regulatory approvals
• Employment contracts
• Non-compete agreements

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Adjusting the Targets Financial Statements
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Developing Discount (Capitalization) Rates

• Capital asset pricing model (CAPM)
• Specific business risk
• Adjusting the CAPM for specific business risk
• Cost of capital
• Accounting based returns
• Price-to-earnings ratio
• The build-up method

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Estimating Capitalization/Discount Rates Using
the Build-Up Method

• P0 FCFE0(1g)
• (COE-g)
• And COE g FCFE1
• P0
• (Rf ß(Rm Rf) Rj Rji) g FCFE1
• 
  P0
• Where P0 Firm value in year 0
• ß Firm s beta
• FCFE0 FCFE in year 0
• g Expected constant growth in
  annual dividends
• COE Cost of equity
• Rf Risk free rate of return
• Rj Firm specific risk
• Rji Marketability risk premium

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Build-Up Method Example
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Things to Remember

• Valuing private firms tends to be more
  challenging than public firms because of the
  dearth of reliable, timely data.
• The purpose of recasting private company
  statements is to calculate an accurate current
  profit or cash flow number.
• By comparing salaries, benefits, etc., with
  industry norms, it is possible to pinpoint
  anomalies.
• The presence of anomalies does not necessarily
  mean that a particularly individual is over
  (under) paid.
• It is crucial to understand the reasons for the
  anomaly before reaching any conclusion.
• The build-up method is often used for
  estimating the discount or capitalization rate
  for private firms because of the presence of high
  levels of firm-specific and marketability
  (illiquidity) risk.