Private company valuation is a complex task even in times of stability. The value depends on the facts and circumstances of each company and the related investment basis and thesis. This has always been true, but it is even more true today. For example, a company in the retail or hospitality industry will have a very different impact from the recent economic changes than a company that is supplying personal protective equipment. With so much uncertainty, three valuation approaches should be considered when estimating the value of a private company or investment in a private company:
- Income Approach: The income approach estimates value based upon the expected cash flows and the estimated required rate of return. How can cash flows be estimated with the increasing uncertainty in the timing and impact of the pandemic? Also, how do you assess the risk and market return with so much volatility and uncertainty? This valuation process will require more detailed questions and investigations such as:
- How were cash flows impacted during the shelter in place period and how quickly will reopening positively impact the business?
- How much governmental assistance has been or will be potentially obtained by the company?
- How will cash flows and future growth be impacted once the world is back to “normal” and what is the estimated time frame to a return to “normal?”
- How much should the estimated market return be impacted with the increasing uncertainty and volatility?
The above is an initial list to consider; however, many other questions will need to be addressed that are specific to each situation.
- Market Approach: The market approach is a frequently utilized methodology due to its core simplicity of applying an observed multiple to a financial metric. However, the simplicity of the approach can lead to pitfalls, especially during a time of extreme volatility and uncertainty. A few considerations unique to the current situation may include:
- What is the correct market price of a publicly traded company? Market prices have been extremely volatile resulting in prices that may or may not reflect the “value” on a particular date. Should an average price over a period of time be considered instead?
- What earnings should be used in calculating the multiple? Should forward earnings or the prior quarter’s earnings be used given the impact of the current economic events? The prior quarter earnings could understate the multiple (i.e., stronger earnings compared with declining market prices); however, forward earnings may not be updated or even available.
- For merger and acquisition transaction multiples, are transactions that occurred when the economy was strong relevant in today’s market?
The challenge is not only to estimate an appropriate market multiple, but also the earnings of the company to which the multiple is applied.
- Asset-Based Approach: The asset approach is used most often in holding companies, asset intensive industries or distressed situations. Distress will be more common given the current environment. The following are some issues to consider when assessing net asset value:
- Should orderly liquidation or forced liquidation be considered?
- Has functional or economic obsolescence been considered?
- Have values of assets, such as property, plant and equipment, been adjusted for the changing market?
- Have the current assets and current liabilities been adjusted for the impact of the current economy, such as the allowance for doubtful accounts or unrecorded liabilities?
The asset approach is an important part of a valuation in an economic decline as it determines the floor value for a company.
Estimating the value of a private company is always a challenge and the recent volatility and market uncertainty only increases the complexity. This complexity heightens the need for experience and expertise to adequately address the risks, uncertainty and valuation considerations associated with a private company.
DHG is positioned to help you embrace the challenges of today with a future-focused approach so you can work towards emerging strong. Please contact your DHG team member and tell us more about your goals.