Valuing Private Middle Market Companies
Various alternative metrics offer a reliable valuation. But these methods can vary, producing misleading results. The worst outcome is an inaccurate representation of value. While a good measure of earnings is key to determining value, earnings are not always easy to pin down. Cash flow and EBITDA can be very different. This makes determining the true value of a company a challenging task.
Earnings are subjective, and often in the eye of the beholder. Buyers and sellers may wrestle over actual value. So, let’s look at the other components that can determine value.
DCF Models and Capitalization Rates
During business valuation, it’s helpful to understand that every business has risks. Sometimes this is related to the company itself. Other times it has to do with the market. Capitalization or discount rates can accurately capture risk.
Discounted cash flow (DCF) analyses forecast earnings over a future period, then discount them against a given discount rate. Determining the proper number, particularly for forecasting future earnings, can be the subject of much dispute between sellers and buyers. This is one of the reasons M&A valuations often use multiples, both of publicly traded entities and those of precedent transactions since this is based on historic or present data, not based on future forecasts.
Publicly traded entities that have reached scale are easier to value with predictable future forecasts. These forecasts are more predictable for larger firms. By contrast, smaller middle market firms lack predictability and industry research. They don’t have teams of researchers gathering useful data. Further, privately held firms have scant incentive to provide a conservative forecast of future earnings as they will not be held to account by the market when they inevitably fail to meet or exceed said lofty forecasts.
It’s nearly impossible to determine capitalization rates for these entities, and even harder to get everyone to agree to the numbers. There is no exact fit.
When seeking public company valuation comparables, there is no shortage of earning metrics. They include price to EBIT, price to EBITDA, price to net income, price to net sales, and many others.
Smaller firms do not have analysts or the market to help determine the real value of the company. This knowledge gap in valuation can prove challenging. Simpler methods can work well. Those include net cash flow, seller’s discretionary earnings, and abbreviated net cash flow.
Private and Public Incentives
There are significant differences in the measurement of earnings between private and public companies. Consider this:
- Public entities are incentivized to maximize the price of stock. They always seek higher earnings, which are boosted by increased sales or decreased costs.
- Most private small and medium sized businesses don’t pay income taxes; their owners do. These entities are often pass-through corporations, allowing the owner to minimize taxes. Public companies, by contrast, move to new locations, seek tax breaks from governments, or creatively structure their businesses. Small businesses rarely have these advantages.
Aggressive depreciation may save tax money, but can skew reinvestment. Depreciation and amortization included in EBITDA attempt to solve this issue by exploring earnings without aggressive depreciation. When seeking real value, even more adjustments may be necessary.
By contrast, public companies are often more true to market. They’re under constant surveillance by regulators and investigators who demand they adhere to rigorous standards.
The Valuation Knowledge Gap in Reasonable Valuation
Incentives and lack of knowledge can affect the way private businesses are valued compared to public entities. In most cases, the numbers from a Quickbooks export of EBIT or EBITDA do not provide accurate performance data.
Adjustments, normalization, and add-backs can offer a true assessment of the company’s value.
Understanding and accounting for differences in public and private entities can help sellers arrive at an appropriate valuation. Buyers too must understand the true value of the company, and that requires a careful valuation strategy.