Valuation Methods in Private Equity

I had a surreal experience at the end of 2008 trying to make sense of investee valuations. While I sat, staring at the snow in anticipation of some profound thought, I realised that all of the noise and clamour of the “financial crisis” had disappeared. It was as if some deity had used a constant and unrelenting snowfall to hypnotise the globe into a cryogenic slumber to give it time to reconsider itself and its actions.

Anyway, after rejoining reality, I wondered what the softening economy and 30-40% falls in public equity markets meant for my firm’s investees. Since times had significantly changed, I had to revisit the EVCA valuation method guidelines to understand how I would be valuing these businesses. In doing this, I thought it would make a worthwhile post to give a very brief overview of the recommendations.

The EVCA uses the same guidelines that many other national private equity associations use, and as such, they recommend the following valuation methods:

Price of a recent investment valuation method – used within 12 months of an investment if there haven’t been any material changes (I think we’d all agree that expectations have materially changed).
Earnings multiple valuation method – using the latest earnings forecast and an appropriate and reasonable multiple for the applicable industry and size of business, with a marketability discount applied.
Net Assets valuation method – only used in cases where the underlying asset is traditionally valued according to specialised methods; such as property or a portfolio of listed investments.
Discounted cash flows valuation method – used in many other circles, but apparently based on too many subjective assumptions to be useful to the time horizon of private equity.

Upon reading the guidelines, you quickly notice support for the concept that something is worth only what someone is willing to pay. I say this because there is a heavy bias towards the earnings multiple valuation method. This is okay with me, but I feel I should make a post in the next few days on the implications of using this valuation method. So stay tuned… and don’t spend too much time staring out into the snow.

The non-public equity funds currently would be reluctant to present a better valuation method to proposed investee company and would argue that they could be at an advantage investing funds in listed corporations that are out there at comparatively lower valuation than proposed investee company. non-public Equity funds normally take into account all tangible and intangible assets of the investee company and can be willing to pay valuation premium solely when there’s one thing distinctive within the company versus competition which may facilitate company gain sustainable competitive advantage.

In this state of affairs, the promoters need to objectively determine necessary price drivers/key success factors for his or her business and need to evaluate objectively how their business fares on these price drivers/key success factors versus comparable corporations. The promoters then got to demonstrate to personal equity funds how they fare higher as compared to alternative comparable corporations on the parameters. Having a powerful whole, a much better distribution network, a growing market share, a capable team, a scalable model while not vital increase in capex, a powerful order book position or having {a cost|a price|a price} effective technology are some such instances of value drivers / key success factors which can be thought-about by PE funds.

The promoters conjointly got to analyse financials of comparable corporations and confirm to PE funds on how they fare higher. Eg – having higher growth rate in sales than trade average, having lower volatility in growth rate in sales than trade average, increase in profit margins over amount of your time than trade average, higher management of operating capital cycle (essentially managing debtors, creditors and inventory higher than comparable companies), having optimum debt equity ratio, lower contingent liabilities, etc will enable promoters in arguing their case for a valuation premium.

Businesses or fractional interests in businesses could also be valued for numerous functions like mergers and acquisitions, sale of secs, and taxable events. A correct valuation method of privately owned corporations largely depends on the reliability of the firm’s historic data. Despite the chance of manager bias, investors and creditors apprehend the market values of a firm’s assets