How much is your business really worth?

The price that a buyer is willing to pay may be much different from the owner’s estimate.

By Daniel D. Bayston

Over the past several years, shareholders of both publicly held companies and closely held concerns have experienced significant swings in the value of their holdings. While shareholders of publicly held companies have been able to measure the magnitude of these changes quite easily, the impact on the value of closely held firms has been less clear.

One indicator of the relative value trends of private companies is the change in multiples being paid for closely held businesses. While details of many transactions involving private companies are generally not publicly disclosed, an annual study conducted by Mergerstat Review has been able to uncover several interesting trends. As the chart below shows, the price/earnings multiples paid for private companies, after rising steadily during the mid-1980s to above 15 to 16 times, have declined significantly over the past four years.

The contraction in multiples that occurred after 1987 is directly related to reductions in price/earnings multiples of public companies following the stock market crash in late 1987. For the first six months of 1991, price/earnings multiples paid for private companies have declined sharply to 9.1 times. This has been caused to a large extent by the lack of credit available to potential buyers to finance acquisitions and has been exacerbated by the depressed level of the U.S. economy. Despite favorable interest rates, lenders have significantly contracted their exposure in new-acquisition-related financings.

While the overall trend in multiples paid for companies has fluctuated during the past decade, the relationship between the size of the company being sold and the multiple paid to the seller has remained fairly constant. Generally, the larger the size of the transaction, the larger the price/earnings multiple paid for the business. Over the past 10 years, multiples paid for businesses involving transactions of $25 million or less were approximately 25 percent lower than multiples paid for businesses that were sold for $100 million or more.

It is not uncommon for owners of private companies to estimate the value of their businesses using what a friend or neighbor sold the business for several years earlier or some other rule of thumb. However, owners discover that the actual price a potential buyer is willing to pay is signficantly different from their rough estimate. The principal objective in assessing value for a closely held company is to determine the price that a willing buyer will pay a willing seller in an arm’s-length transaction, when both parties are duly informed of relevant facts. In the absence of an effective public market, in which value is determined by current measures of supply and demand, fair market value can be determined by analytical techniques. Two common methods used by experts are a comparative company analysis and the discounted cash flow method. There are many factors that must be considered in the determination of fair market value, including:

Critical to assessing the relative importance of the various factors are extensive discussions with senior management to review the company’s history, current operations, competitive position, and likely future financial performance. In addition, a tour of the key operating facilities is important in determining the degree to which the operations are capital-intensive.

From a quantitative point of view, the valuation process involves a thorough analysis of available historical and current financial information. This also includes a review of any available internal financial forecasts. Other sources that are reviewed include industry data and published financial data for comparable public companies.

In the comparative company analysis, it is important to examine market prices and resulting valuation multiples for public companies in businesses that are comparable to the company being valued. These companies should be subject to the same economic forces as the firm being valued, in terms of operations, markets, and government regulation. It is important that investors, in their continuing appraisal of relative investment values, view the public and private companies as similar.

For those closely held companies with several unrelated operations, it may be appropriate to select a different set of comparative companies for each operation. Using this approach, separate valuations can be determined for each business segment based upon its earnings, cash-generating ability, and investment risk.

When a comparison is being made with multiples of publicly traded companies, it should be noted that these multiples (similar to those reported in the Wall Street Journal) reflect valuations that investors make for small portions of a public company’s total stock outstanding. These minority interest prices are typically lower than multiples paid when an entire company’s stock is sold at once. The difference was often seen during the 1980s, when takeover speculation boosted the prices and multiples of many public companies. Historically, investors have paid significant premiums to gain control of a company’s operations and its cash flows. Thus, a valuation should reflect a premium for control likely to be paid by a third-party investor if the percentage of ownership being valued is above 50 percent.

In the past five years, the average premium paid for control of publicly held companies has been from 30 percent to 35 percent. This premium has varied from industry to industry, however, reflecting the different risks and opportunities of the various products and services of the business being acquired. The multiples in the graph below reflect premiums for control.

In the discounted cash flow analysis, it is necessary to make reasonable projections about the future earnings and cash-flow-generating ability of the company, to determine the amount available in each year for distribution to shareholders or reinvestment in the business. These cash flows are estimated for future years and discounted back to a present value to arrive at a current estimate of the value of the business.

An investor would capitalize the projected cash flows at an appropriate rate of return in order to arrive at the present value of such flows. The discount rate is the rate of return an investor would desire to receive on an investment in the business. Such rates of return should reflect macroeconomics as well as factors specific to the industry and company that translate into the degree of perceived risk to achieve these projected results.

The value established in the discounted cash flow approach results in a going-concern value. This contrasts sharply with a liquidation value, which represents only the proceeds expected from an orderly sale of the company’s assets (land, building, inventories, etc.). The discounted cash flow analysis makes the implicit assumption that the company will continue operations for many years into the future.

Since most closely held companies do not guarantee a market for their stock, a discount is sometimes warranted to reflect the risk an investor faces because of this lack of marketability. However, these discounts generally apply when determining the value of a block of stock that is less than 100 percent of the outstanding shares.

After all relevant qualitative and quantitative factors are considered, determination of the fair market value of a closely held company becomes a matter of judgment. It requires a critical understanding of a company’s historical operating record and the unique risks and opportunities that it is likely to face in the years ahead.


Daniel D. Bayston is a vice president and director of Duff & Phelps Financial Consulting Co., a subsidiary of Duff & Phelps Inc., in Chicago.