The Complex Science of Private Company Valuations

With stock market valuations reaching record highs and merger and acquisition activity remaining robust (new deals are occurring daily), it is natural for those involved with private companies to wonder what their businesses are worth. As an investment banker who has taken part in hundreds of privately held business transactions, I’m constantly bombarded with valuation questions. People like to know selling prices so they can compare it with their own business value estimates. This is a natural question, as owners of significant assets do not have a convenient way of valuing them. When someone wants to directly compare his or her business to one that recently sold, I warn them that direct comparisons between private businesses can be very difficult. I liken it to comparing home prices: A house that sells for $1 million, for example, doesn’t mean every (or any) home in the vicinity is worth that much—it could have a higher or lower value. Unless you know the square footage, number of bedrooms, condition of the home that sold, and neighborhood, a direct comparison is not very useful.

When considering the value of a private company, there are various methodologies to employ. One approach is looking at the relative valuations of comparable public companies to determine their multiples of revenue and earnings. This technique works well if the public companies are similar to the private company, but accurate comparisons are more difficult for specialized businesses like medical device contract manufacturers.

Another methodology involves reviewing comparable transactions (recent M&A trades of similar companies). The only drawback to this strategy is the limited information contained within these deals—the lack of data can leave private business owners as much in the dark as they would be comparing selling prices.

Knowing the multiple of a similar transaction is not enough to effectively value another business. For example, a comparable business might have sold for 10x EBITDA (earnings before interest, taxes, depreciation, and amortization). While it would be tempting to merely multiply a business’s EBITDA by 10 and determine the value of the business, it unfortunately is not that simple. With the information available about private transactions being generally quite limited, the first question to consider is what EBITDA is really being used. Is it a trailing 12-month number calculation, next calendar year, current run rate, or has the EBITDA been adjusted somehow? The type of EBITDA number used can yield vastly different valuations. Unless you know exactly what the multiple was based on, you run the risk of being way off in your estimate.

Let’s assume the type of multiple is known. Even under this scenario, too many variables exist to make for an easy comparison. Remember, not all earnings are the same. Two businesses may have identical EBITDAs, but the composition of those earnings may be dramatically different. One company’s EBITDA may be comprised of several stable, long-term contracts with a large amount of repeatable, sustainable business while another may generate its earnings from only one customer with a large one-time order. Should the two businesses be valued equally? Clearly not. Furthermore, there are a number of valuation factors that are not easily reflected in a simple EBITDA number: proprietary processes; intellectual property; contracts; overall growth or contraction; the number, length, and tenure of customer relationships (sole supplier or a secondary supplier; plant capacity; condition of the equipment; depth of the management team; the state of quality systems; sales pipeline; and growth opportunities.

There is a methodology that takes all of these variables into consideration. The purest form of valuation is the discounted cash flow analysis (DCF). DCF simulates a business’s future cash flows and calculates the present value of those cash flows. Constructing a DCF model requires that a number of assumptions be made to account for a business’s future long-term success (considering customers, capacity, proprietary processes, etc.). Then, based on capital costs and the inherent risk in achieving the financial forecast, a discount rate is used to calculate the net present value of cash flows.

This methodology is not without its issues, though. The basic problem with DCF is the number of assumptions that must be made. Projecting future cash flows for the next two years is a difficult task for most privately held businesses, and making accurate projections for the next five to 10 years is almost impossible. In addition, properly assessing risk factors and the cost of capital to select a discount rate is not straightforward. An adjustment to any of these variables results in a materially different valuation.

Valuation Is Part Art and Part Science
If there are no perfect analytical methodologies for valuation, then how should a privately held business think about it? The answer, unfortunately, is not a simple one. Basically, all the approaches must be considered and some subjective analysis conducted to determine a valuation range. Start by examining public comparable companies and recent M&A transactions, and then construct a DCF model. While these three methodologies may yield very different valuations, they will at least create a valuation range “starting point.” Next, start considering non-quantitative factors such as the quality of the earnings, business model, unique capabilities, and growth opportunities. Based on these factors, you can then start targeting a valuation at the higher or lower end of the analytical range.

There are additional factors that must be considered when trying to determine the value of a business in an M&A transaction. It is not enough to look at the business solely as an independent entity. Ultimately, a business is worth what someone is willing to pay for it, so it should be looked at from the perspective of a potential acquirer. Consequently, the analysis required for an acquisition valuation involves a careful examination as to what a potential buyer can do with a business. If a buyer is able to significantly leverage a capability or assets of a business, it can afford to pay more for it than a buyer who is not in a position to leverage a capability.

When dealing with acquisitions, valuations are discussed in terms of multiples. Medical manufacturing firms generally are assumed to be valued as a multiple of annual EBITDA (pre-tax cash flow). Smaller medical device companies, which may not be profitable or just barely gainful, may be valued as a multiple of annual revenues. Though this may seem simple, it is far from straightforward, as a company’s EBITDA is quite different depending upon the buyer.

To take two extremes, consider a large strategic buyer and a private equity (PE) buyer looking to acquire a new platform business. The strategic buyer has a number of potential revenue and cost saving synergies—selling its current products and services to new customers, leveraging excess capacity, leveraging its managerial overhead, and using its preferred pricing with suppliers. The private equity buyer has none of these areas to leverage and relies principally on a low cost of capital. To put this in financial terms, assume a business on a standalone basis has $4 million of EBITDA. The strategic buyer, through its synergies, is able to generate an extra $1 million of EBITDA, meaning that the net EBITDA contribution to it is $5 million. If both buyers can afford to pay 8 times the EBITDA, then the strategic buyer can pay $40 million and the PE firm can pay $32 million. Based on the business’s trailing EBITDA, this would equate to a reported 10x multiple for the strategic buyer and an 8x multiple for the private equity buyer.

So, how can information about transaction multiples best be interpreted? Although multiple information from transactions is useful, careful consideration of a deal’s specific circumstances is perhaps most helpful. But before getting too excited about a very high multiple in a sale to a strategic buyer, keep in mind there might have been various synergies that enabled the buyer to pay that multiple. Another factor to consider is whether or not this is a one-off buyer or there are other similar buyers involved. For another business to command the same multiple, it would need to find a similar type of buyer with extensive synergies. The other extreme, the private equity buyer, is much easier to compare. Since there are fewer synergies and variables, the multiple is a much more accurate representation of what a buyer might expect from a similar type of purchaser.

Given that private company valuation is a combination of both art and science, it is not nearly as straightforward as one would expect. Reviewing market analytics and trading ranges of similar businesses is useful, but it’s not enough. Taking a close look at a business and its industry to determine its relative attributes and shortcomings is really the only effective way to determine an accurate business valuation. Through a combination of analytical analysis and business research, it is possible to determine the valuation of private companies. 

---

Ben Dunn is a managing director with Boston, Mass.-based Covington Associates. For more than 20 years, he has advised medical technology companies in the areas of mergers, acquisitions, investments, and strategic partnerships. Having advised clients on more than 100 transactions, Dunn has represented both private and public companies on both the buy and sell side. He is a frequent speaker at healthcare conferences and the author of numerous articles, including the white paper, “Medical Device Outsourcing Industry: Emerging Trends and Opportunities.”