As opposed to public companies, whose value is determined by the market, private companies need specific techniques to assess their worth. If you are a founder needing investment, knowing how to estimate your business’s worth is essential.
This guide equips founders with the most efficient valuation methods and actionable best practices for accurately assessing a private firm’s worth.
What is a Private Company Valuation?
When an organization is not listed on a stock exchange, a private business appraisal is used to estimate its financial worth. Unlike public companies, private companies don’t have share prices or easily available financial info, so special methods are needed to figure out what they’re worth.
To figure out what your business is worth, you usually compare its revenue, profits, cash flow, and assets with similar companies in the same industry. This kind of assessment is important if you’re looking to sell the business, attract investors, offer stock options to employees, or handle legal matters.
Usually, business valuations incorporate both quantitative strategies including discounted cash flow and comparables together with qualitative inputs such as team strength and the firm’s reputation in the industry. Appraising a private enterprise requires more attention since the data is not publicly available, which makes it necessary to get the help of professionals to come up with the correct estimation.
4 Methods of Private Company Valuation
Privately held firms are commonly evaluated using a variety of methods. The best practice is to use multiple techniques, since each approach has different benefits and flaws.
Discounted Cash Flow
Business worth can be determined using this method by estimating future cash flows and converting them into present terms with a discount rate. Private companies that do not have market prices are especially assessed using this method.
First, make an estimation of the firm’s free cash flow over a future period that you decide—let’s say five years—to perform this calculation. Then, pick a discount rate—usually WACC (Weighted Average Cost of Capital).
Next, find the present value (PV) of each expected cash flow by applying the formula:
In this formula, CF represents the cash flow each year, and r represents the discount rate.
After deciding on the current worth of the cash flows for the predicted period, find out the terminal figure, that is, the estimated amount of the cash flows beyond the predicted period. Usually, this is done using the Gordon Growth Model.
CFₙ₊₁ represents the cash flow in the first year immediately following the forecast period, r is the discount rate, and g is the growth rate for perpetuity.
Then, discount the terminal value to its present value using:
As a last step, sum up the present value of the forecasted cash flows and the terminal value. The figure is going to be your estimate of the business’s enterprise worth.
Example:
Suppose a private firm expects to generate free cash flows of $400,000, $500,000, and $600,000 over the next three years. The appropriate discount rate (WACC) is 9%. To estimate ongoing worth beyond year three, assume a terminal growth rate of 2%.
Present Value of Forecasted Cash Flows
PV = 400,000 / (1 + 0.09)¹ + 500,000 / (1 + 0.09)² + 600,000 / (1 + 0.09)³
= 400,000 / 1.09 + 500,000 / 1.1881 + 600,000 / 1.2950
= 366,972 + 420,840 + 463,320 = $1,251,132
Terminal Estimate as of Year 3:
TV = 600,000 × (1 + 0.02) / (0.09 − 0.02) = 612,000 / 0.07 = $8,742,857
Present Value of Terminal
PV Terminal = 8,742,857 / (1.09)³ = 8,742,857 / 1.2950 = $6,751,240
Calculate the total enterprise worth
= $1,251,132 + $6,751,240 = $8,002,372
While DCF is strong, it can be very accurate only if the assumptions made are of good quality, particularly about the future cash flows and the interest rate.
Comparable Company Analysis (CCA)
This method is about taking a business and matching it with other similar businesses that are publicly traded. One might find it difficult to identify businesses that are exactly the same, however, this method allows you to catch the idea of the industry trends and valuation benchmarks.
To find this out, the first step would be to choose public companies that are in your industry, have approximately the same size, use a similar business model, and have comparable growth rates.
After you have identified your list of comparable companies, the next step is to find their financial information. This includes such things as earnings, revenue, market capitalization, and stock prices.
Having this information, you calculate valuation multiples. The most popular ones are:
EV/EBITDA Ratio = Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortization
Then, take the average multiple (use this when the peer group is very similar and doesn’t have any major differences) or the median multiple (use this when the peer group includes outliers or isn’t very similar) of the peer group and multiply it by the private business’s corresponding metric.
Lastly, change your assumptions to reflect differences like lower liquidity, smaller size, or unusual risks so that you get a more accurate estimate.
Example:
Let’s say you look at a group of public firms in the same industry and according to their latest EV/EBITDA, the average multiple is 7x. The private firm is currently making an EBITDA of $900,000.
Estimated Enterprise Value = EBITDA × EV/EBITDA Multiple
= $900,000 × 7
= $6,300,000
Estimated enterprise worth of the private company: $6,300,000
*The example is based on the EV/EBITDA multiples, as EBITDA numbers are available for the private firm as well as its peers. The P/E ratio was not taken into account since there is no EPS and stock price data for the private company.
Identical public comparables are hard to find, and market conditions or company differences may have an impact on the accuracy. However, customizing for unique risks and employing CCA in combination with other appraisal techniques would be the best approach.
Precedent Transactions Analysis
Precedent transactions analysis is a relative valuation method that looks at a business in reference to other businesses of a similar nature that were sold or transferred recently. This method captures the entire transaction price, including the premium paid for the takeover, and is useful for M&A deals, even though the data can become outdated as market conditions change.
In order to perform this analysis, first identify recent M&A transactions involving companies in the same industry of similar size and business models as the target company, then collect important financial data from each transaction, such as enterprise worth, revenue, and EBITDA.
Next, calculate commonly used valuation multiples like EV/Revenue and EV/EBITDA for each deal.
EV/EBITDA = Enterprise Value / EBITDA
Then, the average or median of these multiples is applied to the target company’s own revenue or EBITDA to estimate its worth.
Finally, take into account the deal aspects and the climate of the market, using considerations including the amount and type of deal, any control premiums, plus synergies and broad market conditions.
Example:
Suppose recent acquisitions of similar companies occurred at an average EV/Revenue multiple of 2.5x. The private company’s revenue is $3 million.
Apply the Multiple:
Estimated Enterprise Value = 2.5 × $3,000,000 = $7,500,000
Adjustment for Strategic Premiums:
If strategic premiums in those deals don’t apply here, a 15% reduction is made:
Adjusted Enterprise Value = 7,500,000 × (1−0.15) = $6,375,000
If the precedent deals included control premiums or strategic synergies that don’t apply to the target private company, adjustments should be made to reflect a more conservative and realistic valuation.
This method gives a solid estimate based on real market activity, but how accurate it is depends on having good data and how similar the past deals really are.
Asset-Based Valuation
An asset-based approach may be suitable for businesses in distress or asset-heavy industries. The fair market value (FMV) of a company’s net assets is the basis for this valuation method.
To estimate the worth of a firm by this method, first find the FMV of the tangible assets such as property, equipment, and inventory and the intangible assets such as patents and trademarks. Not all intangible assets may be recognized on the balance sheet, but they should be identified and assessed if material.
Once the total asset worth is determined, you then need to deduct the fair market value of liabilities from the total assets.
If you are performing a liquidation valuation, then modify the outcome by also taking into account the expenses and any wear and tear on assets.
Example:
Imagine an entity that has the following assets (at fair market value):
- Property: $2,500,000
- Equipment: $800,000
- Inventory: $300,000
- Patents: $400,000
Total Assets = 2,500,000 + 800,000 + 300,000 + 400,000 = $4,000,000
Suppose the entity’s total liabilities are $1,200,000
Net Asset Value Calculation:
= 4,000,000 −1,200,000 = $2,800,000
Adjustment for Liquidation:
If a 25% discount is necessary for a quick sale:
= 2,800,000 × (1−0.25) = $2,100,000
This approach reflects the net asset value of the company, which includes recognized intangibles such as purchased patents. However, it often understates the company’s true market worth because it excludes valuable but unrecognized assets like brand reputation and future growth potential, which are difficult to quantify and do not appear on the balance sheet.
Key Practices in Valuing a Private Company
Following some best practices makes navigating the world of private company valuation easier.
- Apply multiple valuation methods: Understand a firm’s worth and identify any differences from reported figures better by using several valuation approaches.
- Perform comprehensive due diligence: Analyze your business’s activities, finances, and market position carefully, as public information is limited.
- Adjust for company-specific variables: Make your valuation strategy more suitable for the firm’s unique features, e.g., the sector it operates in, its growth potential, and its development stage.
- Take qualitative factors into account: While it’s important to look at the numbers, you also need to consider things like industry trends, what gives the business an edge over others, and how strong the management team is.
- Clearly disclose underlying assumptions: Make it easier to review and tweak later by clearly noting and sharing all the assumptions you used in the valuation.
- Conduct a sensitivity analysis: Evaluate the impact of modifications to critical assumptions on the valuation to comprehend the range of potential outcomes and identify key performance drivers.
- Consult experts when needed: Consider consulting industry specialists or specialized valuation professionals for complex valuations or niche industries.
Accurate Private Company Valuations Made Easy
Understanding a private company’s worth involves analyzing similar businesses, financial performance, and growth potential and using several valuation methods to capture both the numbers and unique business factors.
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