Valuing a Private Firm

Private firms relative to publicly traded firms

Less information available
Looser accounting standards
Higher risk
Higher illiquidity
The owner can be the manager (when unincorporated)

Can standard valuation methods be used?

The value of a private business to be sold to a publicly traded firm
The value of a private business to be sold to another private party
The value of a firm going public (in an initial public offering)

Private firms and IPOs 1

Valuing a Private Firm

Dealing with risk
Bottom-up approach (our favourable approach)
Obtaining beta information from publicly traded firms
Adjusting for leverage, using the following relationship:
Levered = Unlevered 1 +

D
1 TC
E

Note the following (discussed earlier):

We do not have a private business market-value based D/E ratio
Use the firms target leverage if it is specified
Use the industry average D/E ratio assuming it will resemble the

average for the industry.

Private firms and IPOs 2

Valuing a Private Firm

Bottom-up approach (continued)

Expose to total risk : cannot

use CAPM.

Further adjusting beta for non-diversification effect

When investors of a private business are unable to diversify their
risk (because of the typically small number of investors with much
of their wealth invested in the company), they bear the total risk
instead of just systematic (or market) risk.
From the market beta formula, i = M M , we have:
i iM = i M
We call the total beta, which measures the total risk of private
business i relative to the market risk. Therefore, the total beta provides
an optimistic measure of the private companys risk.

Private firms and IPOs 3

Valuing a Private Firm

Bottom-up approach (continued)
Example: To estimate a beta for Sun Hung Kai Properties fast-food
division in LA (an example discussed in week 5), from three
comparable companies we obtained an average unlevered beta of
0.83. Suppose that the average correlation coefficient for these
publicly traded companies with the markets is 55.4%, re-estimate the
cost of equity for Sun Hung Kais fast-food division.
Total unlevered beta = 0.83/0.554 = 1.50
With tax rate of 34% and a target D-to-E ratio of 40%, then:
Total levered beta = 1.50[1+(1-0.34)0.4] = 1.896
Ke = 4% + 1.896(8.4%) = 19.93%

Private firms and IPOs 4

Valuing a Private Firm

Other approaches
Using an accounting beta (which is the sensitivity of a private
firms earnings on the market aggregate earnings)
Using a fundamental beta (from a relationship between beta
and firm fundamental variables based on publicly traded firms
data)
Adding a private-firm premium to cost of equity

Private firms and IPOs 5

Valuing a Private Firm

Dealing with cash flow
For small unincorporated firms, the owner can be the manager and
hence the following issues arise:
Owner salary: needs to be included in operating expenses
Some personal expenses might be consolidated with business

expenses but need to be excluded.

The tax rate can depend on the owners individual tax rate, which is

different from the corporate marginal tax rate.

Example: Review Question #3

Private firms and IPOs 6

Valuing a Private Firm

The discount effect of illiquidity
It occurs because of higher liquidation costs for selling shares of a

privately held company than for a public firms shares.

Average discount: 20-30 percent of estimated value
The effect of illiquidity varies across

Lower

Depending on:

Companies: liquidity of assets and financial situation

Time: liquidity is worth more when the economy is doing badly
Buyers: liquidity is worth more to buyers who have shorter time
horizons and greater cash needs

Private firms and IPOs 7

Growth and Raising Capital

No D: internal retained earning.

When a firms sustainable growth exceeds its actual

growth, it would be unable to generate sufficient growth
from within. Then,
It might just ignore the problem: management can continue

investing in its core businesses despite the lack of attractive

returns, or it can simply sit on an ever-larger pile of idle resources,
looking forward to future investment opportunities.
It can return money to shareholders (to increase dividends or to

buyback existing shares)

As treasury stock

It can buy growth: diversify into other businesses by acquiring firms

with growth opportunities in other, more vibrant industries.

Private firms and IPOs 8

Growth and Raising Capital

Shortage of cash !

When the firms actual growth exceeds its sustainable growth,

it can do the following to obtain fund sources to support growth
To raise external (debt or equity) capital
To use financial remedies (to increase leverage or reduce payout)
To apply business strategies

Profitable pruning: to sell off marginal operations to plow the money back
into remaining businesses
Outsourcing: to purchase an activity to release assets that would
otherwise be tied up in performing the activity
To look for a partner with deep pockets for a merger, such as a mature
company looking for profitable investments for its excess cash flow; a
conservatively financed company that would bring borrowing capacity.
Target company is growing very fast and lack cash:
need another partner to help.

Private firms and IPOs 9

Raising External Capital

Debt capital
By obtaining bank loans
By selling corporate bonds

Public equity capital

Public offerings: new stocks are sold to the public, in which investment
banks are involved and there is a underwriting process.
Private placement: new stocks are sold to a small number of large
investors (e.g., insurance companies, pension funds)

Private equity capital

Private financing for relatively new (often high-risk) businesses,
provided by specialist venture capital firms, wealthy individuals and
investment institutions.
Private firms and IPOs 10

Raising External Capital

Raising equity capital through public offering
Initial public offering (IPO): a companys first equity issue made

available to the public. With the IPO, the formerly privately

owned company becomes public, which is called going public.
Pricing: how to value the new stock challenging

Timing: when should a firm go public market mispricing

Seasoned equity offering (SEO): an issue of equity by an

already listed company to the public.

Pricing: more straightforward, given existing market price
Timing: should a firm sell new shares when its stock is under-priced or
overpriced market mispricing and (existing) stock price response

Private firms and IPOs 11

Raising External Capital

Capital raising from an IPO
Primary shares in an IPO are newly issued shares of common
stock that are sold to investors.
The cash generated from the sale of primary shares are transferred to
the company.

Secondary shares in an IPO are existing shares of common

stock that are sold to investors.
The cash generated from the sale of secondary shares goes to existing
shareholders, but does not increase the number of total shares
outstanding.

Private firms and IPOs 12

Raising External Capital

Underwriting
In a typical underwriting arrangement, the underwriter (investment
bankers) purchase the securities from the issuing firm and then resell
them to the public.
Stock

Stock

Company

Underwriter
Money

Investors
Money

Spread: the price investors pay (to underwriter) is higher than the price the
underwriter pays (to company). The price difference is the spread.

Private firms and IPOs 13

Initial Public Offerings

The process of a public issue
Management must obtain permission from the board of directors.
Firm must file a registration statement with the SEC.
SEC examines the registration during a waiting period.
A preliminary prospectus is distributed during the waiting period.
The preliminary offer price, as a price range, is specified in the prospectus.
If there are problems, the firm is allowed to amend the registration and the
waiting period starts over.

The offer price is finalized and shares are allocated, typically, after a
book-building process

Recommended reading (posted): Inside the Deal That Made Bill Gates
$350,000,000, Fortune (July 1986) a very interesting, informative article

Private firms and IPOs 14

Initial Public Offerings

The book-building process
There is a marketing campaign, the road show, during which

the firms managers make presentations to groups of

institutional investors.
To attract investors and provide them with information on the firm.
To collect information from investors on the market demand.

Book-building: underwriter collects information from potential

buyers before finalizing the offer price

Investors are invited to indicate their willingness to buy the issue.
The book-building information allows the underwriter to construct
the demand curve for the stock.

Private firms and IPOs 15

Initial Public Offerings

Pricing and share allocation
The initial offer price is adjusted and finally determined after the

book-building process is completed. Valuation models are used

to estimate the fair value of IPOs:
Discounted cash flow analysis
Comparable firms multiples

Shares are allocated at the discretion of the underwriters

Underwriters may allocate more under-priced IPOs shares to their
favoured clients
This may help maintain long-term relations between underwriters
and important investors.

Private firms and IPOs 16

Initial Public Offerings

Use of the proceeds and valuation
The proceeds from the offering can be
Taken out of the firm by the existing owners
Used to pay down debt and other obligations
Held as cash by the company to cover future investment needs

The use of proceeds affects the valuation

If taken out of the firm ignore in valuation
If used to pay down debt change the debt ratio, which changes the
cost of capital and the value of the firm
If held as cash by the company to cover future investment needs add
the cash proceeds from the IPO to the valuation of the company

Private firms and IPOs 17

Initial Public Offerings

Difficulty and complexity in pricing an IPO
Private companies tend to have more asymmetric information
(between firms, underwriters, and investors) than companies that
are already publicly traded.
In the presence of market sentiment, the issuing firm may want
to time the market (to choose the timing of the IPO).
Underwriters want to ensure that, on average, their clients earn a
good return on IPOs.

Private firms and IPOs 18

Initial Public Offerings

The phenomenon of PO underpricing
The closing share price on the first trading day is typically much
higher than the offer price.
The first-day return is as high as 20% on average, which is
consistent over time, and across industries and countries.
Potential reasons: various theories are proposed to explain this
phenomenon. Many theories are based on asymmetric
information between different participants in an IPO in different
ways.

Private firms and IPOs 19

Private firms and IPOs 20

Free Cash Flow to Equity (FCFE) Approach

Delayed discussion

Free Cash Flow to Equity (FCFE) Approach

Obtaining value for equity
Discounting dividend payments value of equity per share
Firm value (e.g. by WACC), D value of firms total equity
Discounting cash flow to equity value of firms total equity

Calculating free cash flow to equity (FCFE)

FCFE = FCF Net cash flow to creditors
= FCF (Debt repayments New debt issued)
= FCF (Principal + After-tax interest New debt)
FCF: firms free cash flow (which is unlevered)
After-tax interest expense in a year: D RD (1 Tax rate)

DCF Valuation 22

Free Cash Flow to Equity (FCFE) Approach

Valuation formula
The fair value of the firms total equity is obtained by discounting
the (levered) FCFE by the (levered) cost of equity, RE .

Value of Equity (E) =

=1

FCFEt
1 + RE

NPV (to equityholders) = Value of equity Initial equity investment

Equity value per share =

Value of equity
Number of outstanding shares

DCF Valuation 23

Free Cash Flow to Equity (FCFE) Approach

Example (from the WACC approach example)
To determine the cash flow to equity, we need to calculate the after-tax

interest expense each year:

DRD(1 Tax rate) = $6000.08(1 0.40) = $28.80
Year

-1,000

125

250

375

1,460

Cash flow to creditors

-600

28.8

28.8

28.8

628.8

Cash flow to equity

-400

96.2

221.2

346.2

831.2

Unlevered cash flow

The value of the levered cash flows is:

96.20 221.20 346.20 831.20

Value of Equity =
+
+
+
= $835
1.2
1.2 2
1.2 3
1.2 4
NPV = 835 400 = $435
DCF Valuation 24