Private company appraisals are often derived from public stock data, because it’s more relevant and plentiful. But private and public companies can markedly differ in terms of risk, expected return and liquidity. Appraisals that fail to account for these differences could be making “apples-to-oranges” comparisons.
Searching for relevant data
Private companies tend to keep the details of their ownership transfers close to the cuff. But there are some exceptions. For a fee, some private firms and business brokers disclose deal terms to proprietary databases. In turn, valuators may use these databases to value private companies.
Unfortunately, private transaction databases may lack an adequate sample of comparables or may not provide enough detail about each transaction to offer meaningful comparisons. There’s also the merger and acquisition method, which generates value on a controlling basis. But it may be less relevant when valuing a minority interest in the subject company.
While private deal data is hard to find, public data is plentiful. Public companies are required to report transaction details to the Securities and Exchange Commission (SEC). Their current public stock prices and market capitalizations are also readily available. So, valuators often turn to public stock data when valuing private companies.
For instance, the guideline public company method derives value from pricing multiples based on comparable public companies’ stock prices relative to fundamental financial variables (such as price-to-earnings or price-to-cash-flow).
The income approach also relies on public stock data. A subject company’s rate of return is typically based on public stock market returns. Rates of return are used to discount the subject company’s expected income stream to its net present value. Riskier investments typically warrant higher rates of return, which generates a lower value.
Understanding what’s different
Here are some key differences between private and public companies — though there may be exceptions to these generalizations:
Size. A company must be fairly large to justify public registration costs and ongoing regulatory compliance costs. So, public companies tend to be larger than their private counterparts.
Diversification. Similarly, private companies tend to have fewer lines of business and operate within a smaller geographic radius. They’re more likely to rely on key customers or provide niche products and solutions.
Management quality. Public companies tend to be professionally managed, because they have greater access to financial resources that enable them to pay salaries that top managers expect. Small private firms tend to be run by entrepreneurs and their families. They also may have less access to debt and equity capital than large public corporations.
Financial reporting. Investors want insight into the financial performance of their investments. The SEC requires public companies to issue audited financial statements on a quarterly basis. In contrast, private companies are less likely to provide similar levels of assurance and often provide only year end reports.
Internal controls. Investors and the SEC expect public companies to implement strong internal control systems that include whistleblower hotlines, corporate codes of conduct and internal audit functions. At small private companies, it may not even be feasible to effectively segregate duties, mandate vacations or rotate jobs, for example.
Factoring in differences
Most of these differences boil down to risk. Smaller private firms tend to be riskier than larger public companies. Therefore, they generally warrant higher rates of return or lower pricing multiples. Those are two ways valuators account for the differences between private and public companies in their analyses.
Another key difference relates to marketability. A minority interest in a public company — such as shares of Disney or Microsoft — sells faster and at a more certain price than a minority interest in a small private business. Valuators reflect this difference by taking discounts for lack of marketability, which are often 30% or greater, depending on the nature of the business interest.
Getting it right
Private and public companies differ in many ways, so comparisons between the two types of entities aren’t perfect. Experienced valuators understand how to adjust for these differences, taking care not to double-count the effects when quantifying their discount rates, pricing multiples and marketability discounts.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.