Over the past several years, shareholders of both publicly held companies and closely heldconcerns have experienced significant swings in the value of their holdings. While shareholders ofpublicly held companies have been able to measure the magnitude of these changes quite easily, theimpact 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 paidfor closely held businesses. While details of many transactions involving private companies aregenerally 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 themid-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 inprice/earnings multiples of public companies following the stock market crash in late 1987. For thefirst six months of 1991, price/earnings multiples paid for private companies have declined sharply to9.1 times. This has been caused to a large extent by the lack of credit available to potential buyersto finance acquisitions and has been exacerbated by the depressed level of the U.S. economy. Despitefavorable interest rates, lenders have significantly contracted their exposure innew-acquisition-related financings.
While the overall trend in multiples paid for companies has fluctuated during the past decade, therelationship between the size of the company being sold and the multiple paid to the seller hasremained fairly constant. Generally, the larger the size of the transaction, the larger theprice/earnings multiple paid for the business. Over the past 10 years, multiples paid for businessesinvolving transactions of $25 million or less were approximately 25 percent lower than multiples paidfor 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 usingwhat 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 signficantlydifferent from their rough estimate. The principal objective in assessing value for a closely heldcompany is to determine the price that a willing buyer will pay a willing seller in an arms-lengthtransaction, when both parties are duly informed of relevant facts. In the absence of an effectivepublic market, in which value is determined by current measures of supply and demand, fair marketvalue can be determined by analytical techniques. Two common methods used by experts are a comparativecompany analysis and the discounted cash flow method. There are many factors that must be consideredin the determination of fair market value, including:
Critical to assessing the relative importance of the various factors are extensive discussions withsenior management to review the companys history, current operations, competitive position, andlikely future financial performance. In addition, a tour of the key operating facilities is importantin determining the degree to which the operations are capital-intensive.
From a quantitative point of view, the valuation process involves a thorough analysis of availablehistorical and current financial information. This also includes a review of any available internalfinancial forecasts. Other sources that are reviewed include industry data and published financialdata for comparable public companies.
In the comparative company analysis, it is important to examine market prices and resulting valuationmultiples for public companies in businesses that are comparable to the company being valued. Thesecompanies should be subject to the same economic forces as the firm being valued, in terms ofoperations, markets, and government regulation. It is important that investors, in their continuingappraisal 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 adifferent set of comparative companies for each operation. Using this approach, separate valuationscan be determined for each business segment based upon its earnings, cash-generating ability, andinvestment risk.
When a comparison is being made with multiples of publicly traded companies, it should be noted thatthese multiples (similar to those reported in the WallStreet Journal) reflect valuations that investors make for smallportions of a public companys total stock outstanding. These minority interest prices are typicallylower than multiples paid when an entire companys stock is sold at once. The difference was oftenseen during the 1980s, when takeover speculation boosted the prices and multiples of many publiccompanies. Historically, investors have paid significant premiums to gain control of a companysoperations and its cash flows. Thus, a valuation should reflect a premium for control likely to bepaid 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 from30 percent to 35 percent. This premium has varied from industry to industry, however, reflecting thedifferent 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 futureearnings and cash-flow-generating ability of the company, to determine the amount available in eachyear for distribution to shareholders or reinvestment in the business. These cash flows are estimatedfor future years and discounted back to a present value to arrive at a current estimate of the valueof the business.
An investor would capitalize the projected cash flows at an appropriate rate of return in order toarrive at the present value of such flows. The discount rate is the rate of return an investor woulddesire to receive on an investment in the business. Such rates of return should reflect macroeconomicsas well as factors specific to the industry and company that translate into the degree of perceivedrisk to achieve these projected results.
The value established in the discounted cash flow approach results in a going-concern value. Thiscontrasts sharply with a liquidation value, which represents only the proceeds expected from anorderly sale of the companys assets (land, building, inventories, etc.). The discounted cash flowanalysis makes the implicit assumption that the company will continue operations for many years intothe future.
Since most closely held companies do not guarantee a market for their stock, a discount is sometimeswarranted to reflect the risk an investor faces because of this lack of marketability. However, thesediscounts generally apply when determining the value of a block of stock that is less than 100 percentof the outstanding shares.
After all relevant qualitative and quantitative factors are considered, determination of the fairmarket value of a closely held company becomes a matter of judgment. It requires a criticalunderstanding of a companys historical operating record and the unique risks and opportunities thatit is likely to face in the years ahead.
Daniel D. Bayston is a vice president and director of Duff & Phelps Financial ConsultingCo., a subsidiary of Duff & Phelps Inc., in Chicago.