Lecture 9 Private Company Valuation.pptx

VALUATION & INVESTMENTS (FINC 412) Lecture 9: Valuing a Private Companies Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Valuing a Private Company Learning Outcomes At the end of this lesson, students will be able to: Explain the characteris...

VALUATION & INVESTMENTS (FINC 412) Lecture 9: Valuing a Private Companies Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Valuing a Private Company Learning Outcomes At the end of this lesson, students will be able to: Explain the characteristics of a private company valuation Calculate the value of a private company to be sold to an individual and a listed company Explain the valuation adjustments needed when a private company is going public (IPO) Activities/Methods Lecture, Discussion, Group exercise, Case study and Excel practice Reading and References Main textbook Reading: CFA Material, Equity: Part I; CFA Material, Portfolio Management: Part I Main textbook Reading: Damodaran A. (2012). Damodaran on Valuation: Security Analysis for Investment and Corporate Finance, 2nd Edition, Wiley Finance. Main textbook Reading: Bodie, Kane & Marcus (2019) Investments, 11th Edition, McGraw Hill Practice: KAPLAN Schweser Notes 2018 Exam Preparation, Equity and Portfolio Management: Part I  Valuation Process Valuation is based on expected future performance not past performance and involves: $ Analysis of the Analysis An analysis of the financial Forecast the future economic of the history and prospects of the operations of the Applying acceptable environment industry business, project or asset business, project or valuation methods asset There are various valuation methodologies which may arrive at differing values for a business, project or asset. Agenda Private Company Valuation Initial Public Offering (IPO) Valuation Process of Valuing Private Companies The process of valuing private companies is not different from the process of valuing public companies. You estimate cash flows, attach a discount rate based upon the riskiness of the cash flows and compute a present value As with public companies, you can either value: ◦ The entire business ◦ The equity in the business When valuing private companies, you face two standard problems: ◦ There is not market value for either debt or equity ◦ The financial statements for private firms are likely to go back fewer years, have less detail and have more holes in them. Issues arising when no Market Value Market values as inputs: Since neither the debt nor equity of a private business is traded, any inputs that require them cannot be estimated: ◦ Debt ratios for going from unlevered to levered betas and ◦ Computing cost of capital/WACC. Market value as output: When valuing publicly traded firms, the market value operates as a measure of reasonableness. In private company valuation, the value stands alone. Market price based risk measures, such as beta and bond ratings, will not be available for private businesses. Cash Flow Estimation Issues Shorter history: Private firms often have been around for much shorter time periods than most publicly traded firms. There is therefore less historical information available on them. Different Accounting Standards: The accounting statements for private firms are often based upon different accounting standards than public firms. Intermingling of personal and business expenses: In the case of private firms, some personal expenses may be reported as business expenses. Separating “Salaries” from “Dividends”: It is difficult to tell where salaries end and dividends begin in a private firm, since they both end up with the owner. Why value a private company ‘Show’ valuations: ◦ Curiosity: How much is my business really worth? ◦ Legal purposes: Estate tax and divorce court Transaction valuations: ◦ Sale or prospective sale to another individual or private entity ◦ Sale of one partner’s interest to another ◦ Sale to a publicly traded firm As prelude to setting the offering price in an initial public offering (IPO) You can value a division or divisions of a publicly traded firm: ◦ As prelude to a spin off ◦ For sale to another entity ◦ To do a sum-of-the-parts valuation to determine whether a firm will be worth more broken up or if it is being efficiently run Private to Private transaction In private to private transactions, a private business is sold by one individual to another. There are three key issues that we need to confront in such transactions:  Neither the buyer nor the seller is diversified. Consequently, risk and return models that focus on just the risk that cannot be diversified away will seriously under estimate the discount rates.  The investment is illiquid. Consequently, the buyer of the business will have to factor in an “illiquidity discount” to estimate the value of the business.  Key person value: There may be a significant personal component to the value. In other words, the revenues and operating profit of the business reflect not just the potential of the business but the presence of the current owner. Perceptions of Risk in an Investment (Private owner Vs Listed company) Practice 1 You are valuing Abel Stores, a small, privately owned apparel store for sale to another private individual, who will be investing all of his wealth in the business. The beta for publicly traded apparel stores is 1.20 and the average R-squared across the apparel stories (with the market) is 0.36. What is the beta that you will use, in estimating the cost of equity in this transaction? Practice 2 You are trying to compute the levered beta that you will use to value Abel Stores. The company has a book value of equity of $600 million and a book value of debt of $ 600 million. If the typical apparel store company trades at three times book value of equity and the market value of debt = book value of debt, what is the debt to equity ratio that you will use to compute the beta for Abel Stores? (The marginal tax rate is 40%) Answer  Practice 3 Now assume that you are looking at the income statement for Abel Stores. The business reported $ 500,000 in after-tax operating income last year, but you note that the owner (who fills multiple roles in the business) has not charged herself a salary. You believe that it will take two hired employees to do the work that the owner used to do and that you would have to pay $150,000 to hire these employees. If your tax rate is 40%, estimate the “adjusted” after-tax operating income for last year Answer Practice 4 You have completed your discounted cash flow valuation of Abel Stores, using a total beta and adjusted operating income, and arrived at a value of $ 4.2 million for the equity in the firm. While you have a base liquidity discount of 20% that you usually apply to equity value in a private company, you believe that the discount should be smaller at Abel Stores. Which of the following is a good reason for attaching a smaller discount? A. The total beta already results in a discount on value. B. You feel that your cash flow estimates are precise C. Abel Stores has more revenues than the typical companies that you value D. Abel Stores borrows less money than the typical firm in the retail business E. All of the above Practice 5 The key person discount is the discount attached to a private business to reflect the expected loss in cash flows, as a result of a key person (often the owner) leaving. Assuming that you are the owner of the business and are trying to sell the business, which of the following actions would you take to reduce the key person discount? A. Agree to stay on for a transition phase, where you help the new owner connect with your customers B. Agree not to start a similar business in a 200 km radius, after you sell the business C. Both D. Neither  Practice 6 Assume that you have been asked to value a Angko Restaurant for sale by the owner (who also happens to be the chef). Both the restaurant and the chef are well regarded, and business has been good for the last 3 years. The potential buyer is a former investment banker, who tired of the rat race, has decide to cash out all of his savings and use the entire amount to invest in the restaurant. You have access to the financial statements for the last 3 years for the Angko Restaurant. In the most recent year, the restaurant reported $ 1.2 million in revenues and $480,000 in operating profit. The firm currently has a debt of $750,000 outstanding, with a yearly interest payment of $65,000. Revenue is expected to grow at 10% for the next 5 years and the current return on capital (ROC) is 20% and the restaurant plan to reinvest 50% of its operating profit into the business in next 3 years and 30% reinvestment rate from year 4 to year 5. At the terminal year, operating profit is expected to growth at the GDP rate, which is currently at 3%. The beta for publicly traded restaurant is 1.25 and the average R-squared from the beta regression across the restaurant business (with the market) is 0.45. Angko restaurant debt to capital ratio is 45% (assumed same for privately owned restaurant too). Treasury note rate was 4.25% and 4% is the equity risk premium.  Practice 6 Appendix 1: Angko Restaurant Income Statement and assumptions Assumptions for next 5 3 years ago 2 years ago Last year years $1,200,00 Operating at full Revenue $800,000 $1,100,000 0 capacity Cost of sales -$280,000 -$385,000 -$420,000 35% of revenue Gross profit $520,000 $715,000 $780,000 Wages -$80,000 -$110,000 -$120,000 10% of revenue Other expenses -$120,000 -$165,000 -$180,000 15% of revenue Operating profit $320,000 $440,000 $480,000 Interest expenses -$65,000 -$65,000 -$65,000 $65,000 p.a Profit before tax $255,000 $375,000 $415,000 Taxes -$76,500 -$112,500 -$124,500 30% tax rate Net profit $178,500 $262,500 $290,500  Answer Required A) If Angko Restaurant's pre-tax cost of debt is 7%, calculate the WACC that would be use as discount rate in valuing the company (7 marks) B) Using the assumptions given, Forecast the next 5 years income statement for Angko Restaurant (10 marks) C) Based on (B) above, calculate the equity value of Angko Restaurant using free cashflow to firm (FCFF) by adding a terminal value at year 6 with the formula FCFF yr5 x (1+g)/(WACC-g) and taking into account 20% key person risk and 15% illiquidity risk. (8 marks) Total marks: 25 marks Answer Answer Private to Public listed company The key difference between this scenario and the previous scenario is that the seller of the business is not diversified but the buyer is (or at least the investors in the buyer are). Consequently, they can look at the same firm and see very different amounts of risk in the business with the seller seeing more risk than the buyer. The cash flows may also be affected by the fact that the tax rates for publicly traded companies can diverge from those of private owners. Finally, there should be no illiquidity discount to a public buyer, since investors in the buyer can sell their holdings in a market. Practice 7 As to practice 6 previous, estimate the value of the restaurant assuming now the buyer is a publicly traded restaurant company in the same industry not an individual. Take into account the following; ◦ Change in risk reflected in beta ◦ Change in cost of equity and capital ◦ Key persons risk ◦ Illiquidity Answer Answer Agenda Private Company Valuation Initial Public Offering (IPO) Valuation Private company for initial public offering In an initial public offering, the private business is opened up to investors who clearly are diversified (or at least have the option to be diversified). There are control implications as well. When a private firm goes public, it opens itself up to monitoring by investors, analysts and market. The reporting and information disclosure requirements shift to reflect a publicly traded firm The twists in an IPO Valuation issues: Use of the proceeds from the offering Warrants/ Special deals with prior equity investors Pricing issues: Institutional set-up: Follow-up offerings Use of the Proceeds and valuation The proceeds from an initial public offering can be; Taken out of the firm by the existing owners Used to pay down debt and other obligations Held as cash by the company to cover future reinvestment needs How you deal with the issuance will depend upon how the proceeds are used. If taken out of the firm -> Ignore in valuation If used to pay down debt -> Change the debt ratio, which may change the cost of capital and the value of the firm If held as cash to cover future reinvestment needs -> Add the cash proceeds from the IPO to the DCF valuation of the company Claims from prior equity investors and valuation When a private firm goes public, there are already equity investors in the firm, including the founder(s), venture capitalists, private equity and other equity investors. If existing equity investors have special claims on the equity, the value of equity per share has to be affected by these claims. Specifically, these options need to be valued at the time of the offering and the value of equity reduced by the option value before determining the value per share. The Investment Banking guarantee… Almost all IPOs are managed by investment banks and are backed by a pricing guarantee, where the investment banker guarantees the offering price to the issuer. If the price at which the issuance is made is lower than the guaranteed price, the investment banker will buy the shares at the guaranteed price and potentially bear the loss. Private company valuation: Closing thoughts The value of a private business will depend on the potential buyer. If you are the seller of a private business, you will maximize value, if you can sell to. A long term investor Who is well diversified (or whose investors are) And does not think too highly of you (as a person) Summary The key messages from this session are: DCF valuations are based on the premise that a company’s value equals the value of the future cash flows generated by the company discounted at the required rate of return demanded by the investors. Two stage DCF valuation models are common and are made up of a finite forecast period and a post-forecast period referred to as the continuing value or terminal value. Forecasting free cash flows involves a detailed understanding of cash flow drivers such as revenues, operating margins, tax rates, working capital and capital expenditure. Click icon to add picture Thank you for listening Q&A Investment useful links – https://www.investopedia.com/terms/d/dcf.asp – https://www.investopedia.com/terms/f/freecashflow.asp – http://www.morganstanley.com – http://www.globalinsight.com – http://www.yardeni.com