The IRS provides some valuable insight to the important issues in valuing companies which Deal Capital’s philosophy closely follows (value is a prophesy of the future which requires an understanding the Company, industry, economy and future , potential of the Company).
In addition the IRS strongly emphasizes/encourages the use of market comparisons which we have not used significantly in the past. Their are significant structural differences between the public market of large corporations and privately held business that make such comparisons very questionable. However, many of our clients are used to hearing PIE ratios of comparable traded companies which we need to be able to explain.
Following is a brief listing of reasons why our valuations will typically result in P/E ratios from 3 to 6 times while public companies may trade from 10 to 20 times.
A History vs. Base Year -P/E ratios of public companies are typically based on the last year of history while clients will tend to focus on the base year or year one when calculating their PIE ratio.
Marketability Discount – The lack of liquidity significantly reduces value. studies of sales of restricted stocks in publicly traded companies and stocks of private companies that subsequently went public sold for discounts ranging from 42′ to 74′ of their public counterparts (see “Valuing a Business -The Analysis and Appraisal of Closely Held Companies” chapter 10 by Shannon
P. Pratt). While the transactions in these studies related to restricted/unregistered stock the purchaser likely new that the stocks would be freely trading in the near future as restricted stock are generally restricted for a limited duration and the unregistered companies went public in the near future. As many of our clients are not prime candidates for a public offering in the near future the prospects of future liquidity are lower which should result in a marketability discount higher than these studies.
Diversification/Size -Public companies are generally significantly larger and more diversified than our clients. This diversification and size significantly reduces the level of risk and consequently allows for a higher multiple for the public market. Diversification includes geographic territory, products and customers.
Organizational-Structure -Public companies due to their size typically have a strong management structure in place. Conversely, many privately held business are highly dependent on the owner and have a lean organizational structure which tends to make them highly dependent on a few key individuals.
Comparability -Are companies really comparable. Is the asset structure, degree of leverage, management structure, etc. really comparable. By comparing the P/E ratio of a public company in the same SIC code with out giving consideration to all of the other factors that effect risk/value the individual is blinding assigning value.
Cost To Go Public -The discount for lack of liquidity should at a minimum be equal to the cost of going public for a company that is a candidate for a public offering and higher for a company that is not a candidate. Cost of a public offering can easily range from 15% to 25%.
The number of reasons why our values will typically be lower
The number of reasons why our values will typically be lower than the value of publicly traded companies is endless. However, the above list points out that it is not unusual for a private company to sell for 25% to 50% of public counterparts. This is sometimes even less, especially when middle-market multiples are depressed.