Private Company Valuation

5 minutes 5 Questions

Private company valuation is a critical component of equity valuation, especially within the Chartered Financial Analyst (CFA) Level 2 curriculum. Unlike public companies, private firms lack readily available market prices, necessitating alternative valuation methodologies. The primary approaches t…

Private Company Valuation

Private company valuation is a crucial concept for CFA Level 2 candidates to understand. It involves determining the worth of a company that is not publicly traded on a stock exchange.

Importance:
Private company valuation is essential for various purposes, such as mergers and acquisitions, raising capital, estate planning, and tax compliance. As a financial analyst, you may be required to provide an accurate valuation of a private company to help stakeholders make informed decisions.

What it is:
Private company valuation is the process of estimating the economic value of a company that is not listed on a public stock exchange. Unlike public companies, private companies do not have readily available market prices for their shares. Therefore, valuation techniques must be applied to determine their fair value.

How it works:
There are several methods used to value private companies:
1. Discounted Cash Flow (DCF) Method: This method involves estimating the company's future cash flows and discounting them back to the present value using an appropriate discount rate.
2. Comparable Company Analysis: This approach compares the private company to similar publicly traded companies, using valuation multiples such as Price-to-Earnings (P/E) or Enterprise Value-to-EBITDA (EV/EBITDA).
3. Asset-Based Valuation: This method calculates the value of a company based on the fair market value of its assets minus its liabilities.

Answering Questions on Private Company Valuation:
When faced with questions on private company valuation in the CFA exam, follow these steps:
1. Identify the valuation method being used or required in the question.
2. Gather the necessary information, such as financial statements, growth rates, and discount rates.
3. Apply the appropriate valuation technique, ensuring that you use the correct formulas and assumptions.
4. Interpret the results and provide a clear explanation of your valuation.

Exam Tips: Answering Questions on Private Company Valuation
1. Read the question carefully to determine which valuation method is most appropriate.
2. Pay attention to the assumptions provided in the question, such as growth rates and discount rates.
3. Show your workings and calculations clearly, as partial credit may be awarded for correct steps even if the final answer is incorrect.
4. Be aware of the limitations and assumptions of each valuation method and discuss them when required.
5. Practice various private company valuation questions to familiarize yourself with the different techniques and their applications.

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CFA Level 2 - Private Company Valuation Example Questions

Test your knowledge of Private Company Valuation

Question 1

When valuing a high-growth private technology company using the discounted cash flow (DCF) method, which of the following is the most appropriate approach to estimate the company's cost of equity?

Using the capital asset pricing model (CAPM) with a higher beta to reflect the company's higher risk profile compared to mature public companies Estimating the cost of equity based on the average return on equity (ROE) of comparable public companies, adjusting for the private company's smaller size and limited liquidity Applying the risk-free rate as the cost of equity, as the company's future cash flows are highly uncertain

Correct Answer: Using the capital asset pricing model (CAPM) with a higher beta to reflect the company's higher risk profile compared to mature public companies

When valuing a high-growth private technology company using the discounted cash flow (DCF) method, the most appropriate approach to estimate the company's cost of equity is using the capital asset pricing model (CAPM) with a higher beta to reflect the company's higher risk profile compared to mature public companies. The CAPM takes into account the systematic risk of the company by incorporating the beta, which measures the sensitivity of the company's returns to market movements. For a high-growth private technology company, the beta should be adjusted upward to reflect the higher risk associated with the company's growth potential, lack of liquidity, and limited operating history compared to established public companies. Applying the risk-free rate as the cost of equity is not appropriate because it does not account for the company's specific risks and growth potential. The risk-free rate is more suitable for valuing very low-risk investments, such as government bonds. Estimating the cost of equity based on the average ROE of comparable public companies, even with adjustments for size and liquidity, may not fully capture the unique risks and growth prospects of the private technology company. The CAPM with an adjusted beta is a more theoretically sound and widely accepted approach in this case.

Question 2

When using the discounted cash flow (DCF) method to value a private company, which of the following is the most appropriate discount rate to apply to the company's projected cash flows?

The risk-free rate, as it represents the minimum return an investor would expect for any investment The company's cost of debt, as it reflects the current borrowing rate for the company and is more stable than the cost of equity The weighted average cost of capital (WACC), which accounts for the company's cost of debt and cost of equity

Correct Answer: The weighted average cost of capital (WACC), which accounts for the company's cost of debt and cost of equity

The weighted average cost of capital (WACC) is the most appropriate discount rate to apply when using the discounted cash flow (DCF) method to value a private company. The WACC takes into account the company's cost of debt and cost of equity, providing a comprehensive measure of the company's cost of capital. It represents the minimum return that a company must earn on its existing assets to satisfy its creditors, owners, and other providers of capital. The risk-free rate is not appropriate because it does not account for the specific risks associated with the company being valued. The company's cost of debt alone is also not sufficient, as it ignores the cost of equity, which is a significant component of a company's capital structure.

Question 3

When valuing a private company using the guideline public company method, which of the following is an appropriate valuation multiple to use?

Price to Earnings ratio, adjusting for the private company's lack of liquidity and higher risk profile Enterprise Value to EBITDA Market Capitalization to Book Value of Equity ratio, as it captures the company's growth potential

Correct Answer: Enterprise Value to EBITDA

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