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CFA Level II Equities > Reading 39 - Private Company Valuation > Flashcards

Reading 39 - Private Company Valuation Flashcards

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1
Q

What are some of the company specific characterstics that distinguish private and public companies?

A
  1. Stage of lifecycle
  2. Size
  3. Quality and depth of management
  4. management/shareholder overlap
  5. short term investors
  6. quality of financial and other information
  7. taxes
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2
Q

What are some of the stock specific differences between private and public firms?

A
  • liquidity
  • restrictions on marketability
  • concentration of control
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3
Q

What are the 3 reasons for valuing private companies?

A
  1. Transaction Related Valuations - are necessary when selling or financing a firm
  2. Compliance Related Valuations - are performed for legal or regulary reaons and primarily focus on financial reporting and taxes
  3. Litigation Related Valuations - may be required for shareholders suits, damage claims, lost profits claims, or divorce settlements
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4
Q

What are the different scenarios when Transaction Related Valuations would be used?

A
  • Venture capital financing
  • Initial Public Offering
  • Sale in an acquisition
  • Bankruptcy proceeding
  • Performance Based Managerial Compensation
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5
Q

What are the different scenarios when Compliance Related Valuations would be used?

A
  • Financial Reporting
  • Tax Purposes
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6
Q

What are the 3 major approaches to private company valuation?

A
  1. Income Approach
  2. Market Approach
  3. Asset-based Approach
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7
Q

Explain the Income Approach in private company valuation….

A

Values a firm as the present value of expected future income.

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8
Q

Explain the Market Approach in private company valuation….

A

values a firm using the price multiples based on recent sales of comparable assets

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9
Q

Explain the Asset-Based Approach in private company valuation….

A

Values a firm’s assets minus its liabilities

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10
Q

Explain the Capitalized Cash Flow method…

A

A single measure of economic benefit is divided by a capitalization rate to arrive at firm value, where the capitalization rate is the required rate of return minus a growth rate

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11
Q

What factors require adjustment when estimating the discount rate for private companies?

A
  1. Size premiums
  2. Availability and cost of credit
  3. Acquirer versus target
  4. Projection risk
  5. Lifecycle stage
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12
Q

Given the below data, calculate CAPM, Expanded CAPM and the Build-Up method…

Risk Free Rate = 3.6%

Equity Risk Premium = 6%

Beta = 1.3

Small Stock Premium = 3%

Company Specific Risk Premium = 2%

Industry Risk Premium = 1%

A

CAPM = 3.6%+1.3(6%) = 11.4%

expanded CAPM , a small stock premium and company specific risk premium is added

= 3.6%+1.3(6%)+3%+2%=16.4%

Build METHOD, beta is omitted from the expanded CAPM but an industry risk premium is added

=3.6%+6%+3%+2%+1%=15.6%

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13
Q

What are the 3 Market approach methods for valuing a private company?

A
  1. Guideline Public Company Method (GPCM) - uses price multiples from trade data for public companies, with adjustments to the multiples to account for differences between the subject firm and the comparable
  2. Guideline Transactions Method (GTM) -prior acquisition values for entire /public and private) companies that already reflect any control premiums are used, so no controllig interest adjustment is necessary
  3. Prior Transactions Method - uses transactions data from the stock of the actual subject company and is most appropriate when valuing minority interests
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14
Q

When estimating a control premium, what factors should be considered?

A
  1. Transaction type- if strategic the price will be higher than if it is mearly a financial transaction
  2. Industry conditions- if there has already been a flurry of industry acquisition activity,the company may already reflect some premium for control. Adding more of a premium may overstate its value
  3. Type of consideration- Is it cash or stock for the deal? Is the company being purchased with “overvalued” shares?
  4. Reasonableness- Does the valuation make sense? Was it already overvalued and an additional control premium isn’t warranted….
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15
Q

When using multiples from historical transactions for the Guideline Transaction Method (GTC), what issues should be considered?

A
  1. Transaction type
  2. Contingent consideration
  3. Type of consideration
  4. Availability of data
  5. Date of data
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16
Q

Describe the asset based approach to private company valuation…

A

estimates the value of firm equity as the fair value of its assets minus the fair value of its liabilities. It is generally not used for going concerns.

17
Q

When might the asset-based approach be appropriate to use?

A
  1. firms with minimal profits and little hope for better prospects
  2. finance firms like banks, where their asset and liability values can be based on market prices
  3. Investment firms such as REITs and Closed End Fund firms
  4. small companies or early stage companies with few intangible assets
  5. natural resource firms where assets can be valued using a comparable of sales
18
Q

How do you determine the discount for lack of control (DLOC) of a company?

A
19
Q

Explain the Discount for Lack of Marketability (DLOM)….

A

If the position cannot be easily sold, there will be a discount because of its lack of marketability. It is often the case that if there is a DLOC there will also be a DLOM

20
Q

What are some examples of what would increase or decrease the Discount for Lack of Marketability (DLOM)?

A

Increase

  • Greater risk and value uncertainty
  • Contractual restrictions on selling stock

Decrease

  • an impending IPO or firm sale
  • the payments of dividends
  • earlier, higher payments (ie shorter duration)
  • a greater pool of buyers
21
Q

What are the 3 methods an analyst can use to estimate a DLOM?

A
  1. The price of restricted shares is used.
  2. The price of pre-IPO shares is compared to the post-IPO price
  3. estimate the DLOM as the price of a put option divided by the stock price,where the put used is at the money
22
Q

If there is a DLOC of 20% and a DLOM of 13%, what is the total discount???

A

they are multiplicative, not additive!!!

= 1- [(1-DLOC)(1-DLOM)]

=1-(0.8*0.87)

23
Q

What are some of the challenges involved with the implimentation of appraisal standards in valuing private businesses?

A
  1. Compliance with these standards is usually at the discretion of the appraiser because most buyers are unaware of them
  2. since most valuation reports are private, it is very difficult for organizations to ensure compliance to the standards
  3. valuation will depend on the definition of value used
24
Q

Calculate the normalized EBIT for both a financial and strategic buyer based on the information below…..

Reported EBITDA $6,700,000

Current Executive Compensation $800,000

Market Based Executive Compensation $650,000

Current SG&A expenses $8,100,000

SG&A expenses after synergies $7,300,000

Current lease rate $200,000

Market Based lease rate $250,000

A

**Financial Buyer: ** Will reduce the exec compensation but pay the higher lease rate

= 6,7000,000 +(800,000-650,000)-(250,000-200,000)

= 6,700,000 + 150,000 - 50,000

= 6,800,000

_Strategic Buyer: _Will reduce the exec compensation but pay the higher lease rate and also include the benefit of SG&A synergies

= 6,7000,000 +(800,000-650,000)-(250,000-200,000) + (8,100,000-7,300,000)

=6,7000,000+150,000-50,000+800,000

=$7,600,000

25
Q

Given the following figures, calculate the FCFF. Assume the earnings are normalized and that capital expenditures will equal depreciation + 4% of incremental revenue

Current Revenues: $10,000,000

Revenue Growth : 5%

Gross Profit Margin: 20%

Depreciation Expense as % of sales : 1%

Working Capital as % of sales : 12%

SG&A expenses : $1,600,000

Tax Rate : 40%

A

Revenue 10,500,000 <- (10,000,000*1.05)

COGS 8,400,000 <- (10,500,000*0.80)

Gross Profit 2,100,000

SG&A 1,600,000

Pro Forma EBITDA 500,000

Deprec and Amort 105,000 <– (10,500,000*1%)

Pro Forma EBIT 395,000

Pro Forma taxes on EBIT 158,000 <- (395,000*40%)

Operating Income AT 237,000

FCFF Adjustments:

Plus : Depr and Amort 105,000

Minus: Capital Exp 125,000 <- (105,000 + (10,500,000*4%)

Minus: Increase in Work Capital 60,000 <-(.12 * (10,500,000-10,000,000))

FCFF = 157,000

26
Q

Using the following figures, calculate the value of equity using CCM (Capitalized Cash Flow Methold), assuming the firm will be acquired,

Normalized FCFE CY : $2,200,000

Reported FCFE CY: $1,800,000

Growth rate of FCFE : 6%

Equity Discount Rate: 18%

WACC : 14.5%

Risk Free Rate: 4.2%

Cost of debt: 11%

MV of Debt

A

value of equity = FCFE1/r-g

**so we need to esitmate FCFE at Yr 1, then plug in the remaining #s

27
Q

Using the following figures, calculate the value of the firm using the EEM ( Excess Earnings Method) …..

Working Capital : $400,000

Fixed Assets : $1,800,000

Normalized Earnings : $235,000

Required return on working capital : 4%

Required return on fixed assets : 12%

Growth rate of residual income : 3%

Discount rate for intangible assets : 16%

A

Step 1 : Calculcate required return for working capital and fixed assets

Fixed Assets = (1,800,000 * 12%) = 216,000

Working Capital = (400,000 * 4%) = 16,000

Step 2 : Calculate Residual Income

residual income = 235,000- 216,000 - 16,000 = 3,000

Step 3 : Value the intangible assets using the formula for a growing perpetuity

= (3,000 * 1.03) / (0.16-0.03) = 23,769

Step 4 : Sum the asset values to arrive at total firm value

= 400,000+1,800,000+23,769 = 2,223,769

28
Q

An analyst is valuing a private firm on the behalf of a strategic buyer and deflates the average public co multiple by 30% to account for the higher risk of a public firm. Given the following, calculate the value of firm equity using the GPCM

Market value of debt : 2,600,000

Normalized EBITDA : 27,100,000

Average public co MVIC/EBITDA : 9.0

Control Premium from past transaction: 25%

A

Step 1 : Adjust the MVIC/EBITDA multiple

9.0 * (1-0.30) = 6.3

Step 2 : Use adjusted multiple against normalized EBITDA

6.3 * 27,100,000 = 170,730,00

Step 3 : Subtract out the debt to determine equity value

170,730,000 - 2,600,000 = 168,130,000

Step 4 : Since is a strategic buyer, add control premium

168,130,000 * (1.25) = 210,162,500

29
Q

When using the Capitalized Cash Flow Model (CCM), do you use the normalized or reported free cash flow figures in the equation?

A

NORMALIZED

30
Q

When using the Excess Earnings Model (EEM), should book value of assets or fair value of assets be used in the equation?

A

FAIR VALUE

CFA Level II Equities (10 decks)

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