Financial Analysis: Debt-to-Equity Ratio

Private Company Valuation

• There are several reasons to value a private company, including:
  • "Show" valuations (e.g., curiosity, estate tax, or divorce court)
  • Transaction valuations (e.g., sale or prospective sale to another individual or private entity, sale to a publicly traded firm, or IPO)
  • Valuing a division or divisions of a publicly traded firm (e.g., spin-off, sale to another entity, or sum-of-the-parts valuation)

Key Issues in Private-to-Private Transactions

• Neither the buyer nor the seller is diversified, which affects risk and return models
• The investment is illiquid, requiring an "illiquidity discount" to estimate the value of the business
• Key person value: the business's value reflects the owner's presence and potential

Beta Estimation for Private Companies

• The beta for publicly traded companies in the same industry can be used as a starting point
• However, the beta may need to be adjusted for the private company's specific characteristics and risks
• The average R-squared from the beta regression across the industry can be used to estimate the beta for the private company

Debt-to-Equity Ratio and Beta Estimation

• The debt-to-equity ratio can be estimated based on the book value of equity and debt
• The market value of debt can be assumed to be equal to the book value of debt
• The beta can be estimated using the debt-to-equity ratio and the beta of publicly traded companies in the same industry

Adjusted Operating Income

• The owner's salary may not be reflected in the income statement, and should be added back to estimate the adjusted operating income
• The tax rate can be used to estimate the adjusted operating income after taxes

Discounted Cash Flow (DCF) Valuation

• The DCF valuation method can be used to estimate the value of a private company
• The cost of equity and debt can be estimated using the CAPM and the pre-tax cost of debt
• The WACC can be calculated using the cost of equity and debt, and the debt-to-equity ratio

Private Company Valuation Issues

• There is no market value for the debt or equity of a private company
• The financial statements may have fewer years of data, less detail, and more errors
• The accounting standards may be different from those used by public companies
• Personal and business expenses may be intermingled, and salaries and dividends may be difficult to distinguish

Key Person Discount

• The key person discount is a discount applied to the value of a private company to reflect the expected loss of cash flows if the key person (often the owner) leaves
• The discount can be reduced by taking actions to mitigate the risk of the key person leaving, such as:
  • Agreeing to stay on for a transition phase
  • Agreeing not to start a similar business in a certain radius

Liquidity Discount

• The liquidity discount is a discount applied to the value of a private company to reflect the lack of liquidity
• The discount can be estimated based on the size and type of the company, and the market conditions

Valuation of Angko Restaurant

• The Angko Restaurant has a debt of $750,000 and a yearly interest payment of $65,000
• The restaurant has a revenue growth rate of 10% for the next 5 years, and a return on capital (ROC) of 20%
• The reinvestment rate is 50% for the next 3 years, and 30% from year 4 to year 5
• The operating profit is expected to grow at the GDP rate (3%) in the terminal year
• The beta for publicly traded restaurants is 1.25, and the average R-squared from the beta regression is 0.45
• The debt-to-capital ratio is 45%