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Discounted Cash Flow Estimation: A Private Equity Valuation Method

Discounted Cash Flow Estimation: A Private Equity Valuation Method

Whether you’re actively selling your privately-held business or not, as the owner of a company you may wonder about the value of your business and how it will impact your options. In that case, you may want to consider a discounted cash flow analysis.

But there are multiple ways to value your privately-held company, and not one method is more accurate then another. Instead multiple methods are used to narrow in on an appropriate value range. Business bankers or brokers, such as Sunbelt Business Brokers, will use different methods to produce different numbers, but then add their subjective insight to determine a final valuation. And for each valuation a variety of non-qualitative factors are used to come up with an accurate valuation for your privately-held company.

In this blog, we will consider one of those valuation methods – Discounted Cash Flow.

Discounted cash flow is a simple concept: the value of any given business is equal to the sum of all future cash flow of that business, discounted to reflect today’s value. This type of valuation is only as good as its assumptions and a huge amount of discretion comes into play if projecting 5-10 years into the future.

  • Cash Flow Estimation: A private company’s cash flow history is typically more obscure than a publicly-held company, leading bankers and brokers to be careful when making projections. Why? Private firms are usually younger, don’t face the information sharing requirements of publicly-traded companies and they sometimes don’t account for the true cost of running the company. How often have you heard of the owner of a privately-held company taking a below-market wage to keep costs down?

Bankers and brokers will have to rely heavily on assumptions and possibly adjust accounting  principles to do the type of analysis on a privately-held company. One thing that may be considered is what is the current market cost of the owner,  especially if they are underpaying themselves.

  • Discount Rate Estimation: The discount rate is the return an investor requires from an investment. If the investment is risky, an investor will want a higher discount rate.

Private companies are not typically diversified, leading to a riskier investment. Another  consideration is the expected  longevity between private-holdings and publicly-traded companies. Private-holdings with a key founder involved usually have shorter expected lifespans.

  • Control Premiums and Illiquidity Discounts: These two scenarios need to be taken into account for a proper valuation of a privately-held firm.

The control premium derives control and the value that control can realize. Unlike purchasing  shores of a publicly-traded firm, the purchase of a privately-held company comes with a great deal of control. If the business was poorly run and the  new owner believes he can improve performance financially – there will be a significant control premium that needs to be added into the valuation.

As for an illiquidity discount, the buying and selling shares in a public firm has a very small transaction cost. Not so with a privately-held firm. The resources and time required in a private sale can be significant. A business valuation should take into account those additional costs. An illiquidity discount can be attributed with a 20-30 percent sales price discount vs. a public-held company purchase.

Discounted cash flow valuations can be powerful if used properly, but there are limits to estimating cash flows and discount rates.

Most buyers may attack many of the assumptions of a private company’s growth. That is why working with a banker or certified broker, like Sunbelt Business Brokers, is important and be honest with your sales team on line items that are predictable and which are variable. A tiny change in growth rates of cash flow or discount rates can cause a huge swing in your valuation.

By being honest with yourself and your banker or broker you can get a better valuation and help your sales team negotiate a better price with buyers.

Statistics in this article were found at Axial Forum.