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How to Value a Private Company: 5 of the Best Metrics to Look at During Your Valuation

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How to Value a Private Company: 5 of the Best Metrics to Look at During Your Valuation

Posted on:
December 16, 2021
Time to read:
5 minutes

Valuations are important to calculate when you’re looking to invest in different companies. These calculations are meant to measure their progress and compare it to industry averages, helping you determine whether or not a company might be a good investment. 

When you or your financial advisor are valuing a public company, you’ll typically have access to a wealth of information that’s been made publicly available. For private companies, however, you’ll have less information available and the resulting business valuations tend to be less precise.

Challenges of Knowing How to Value a Private Company

Valuing a public company is relatively straightforward since its market value is determined by multiplying its stock price by the number of its outstanding shares. This is known as market capitalization.

Investors can also get more information about public companies through the accounting and reporting standards they must adhere to. For example, the Securities and Exchange Commission requires them to report their annual and quarterly earnings to its shareholders.

Private companies are often newer and smaller than their well-established, public counterparts. Consequently, they usually lack an extensive financial track record, or financial information may not be shared with the public regularly, if at all. As a whole, because there is less information available to the public, private companies can be much harder to value.

How Public Companies Are Typically Valued

It’s often useful to use more than one of the following valuation methods for publicly-traded companies:

  • The PE (Price-to-Earnings) Ratio – This is one of the most popular ways to determine whether a company’s stock price is overvalued or undervalued. It shows what the market is willing to pay for a stock based on its past or future earnings.
  • The Price-to-Cash Flow Ratio – This ratio measures the value of a stock’s price relative to its operating cash flow. Since cash flow is more difficult to manipulate than earnings are, some analysts prefer this method to the PE Ratio.
  • Dividend Yield – This method is mainly used among income-oriented investors, and it’s calculated by dividing a company’s annual dividend per share by a stock’s market price.
  • The Price-to-Sales (P/S) Ratio – This ratio multiplies the number of a company’s outstanding shares by the share price and then divides by the company’s total revenue over the past 12 months.

How Is a Private Company Valued?

Many of the metrics listed above won’t work when valuing a private company, simply because the information isn’t publicly available. Instead, some of the following metrics can be used when you need to know how to value a private company:

  1. Comparable Company Analysis (CCA) – The most common way to estimate the value of a private company, a CCA looks at public companies of similar size, age and growth rates to use as a comparison. Direct competitors are frequently used as comparisons as well.
  2. EBITDA Multiple – This figure takes a private company’s enterprise value and divides it by the company’s earnings before interest taxes, depreciation, and amortization.
  3. Estimating Discounted Cash Flow – Looking at the discounted cash flow of similar companies can be a useful comparison when valuing private companies. This is done by estimating the revenue growth of the private company by averaging this figure from companies in its peer group. Estimated changes in operating costs, taxes, and working capital are then used to calculate free cash flow.
  4. Calculating Beta – This method involves looking at the average beta (a measure of volatility when compared to the broader market), tax rates, and debt-to-equity ratios for similar public firms. It also requires calculating the weighted average cost of capital.
  5. Determining Capital Structure – For insight into the capital position of private companies, most professional financial analysts or investment advisors use three important ratios: debt ratio, debt-to-equity ratio, and capitalization ratio.

Valuation With the Help of a Professional

Here at Tumwater, we normally recommend that our clients not buy individual stocks. Instead, we would rather see clients taking advantage of mutual funds and exchange traded funds to build fully-diversified portfolios.

Rather than taking a stock analyst’s word for it, it may be more useful to forecast your own estimate of the earnings and profits you expect a company to generate while you plan to own stocks of it. This allows you to more appropriately value the company for your investment time horizon, comparing your estimates to the current market price to see if the market overvalues or undervalues it.

Ultimately, we want to help our clients buy good companies at good prices and hold on to those for the long term. An investment strategy that gets thoroughly diversified, rebalances when the portfolio drifts from its target mix, and holds on through the ugly times does exactly that. Sign up for our Retirement Income Academy course to learn how you can begin designing your investment strategy.

Disclosure:

Tumwater Wealth Management is a registered investment adviser and may only conduct business in states where it is registered or exempt. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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