How the Stock Market Affects the Valuation of Privately Held Companies – Part II

Demystifying Valuation, Economic Damages + Forensic Accounting

Everyone is aware of the large swings in the overall stock market over the past several years with daily gains and losses of over 3 percent and weekly gains and losses of over 25 percent. On Tuesday we covered the income approach, today we cover the market approach.

The Market Approach
The market approach utilizes market data as a proxy for determining a value indication for the subject privately held company.  The following is a discussion of the guideline publicly traded company method which relies heavily upon stock market data as of the valuation date.

Applying the guideline publicly traded company method involves comparing the subject company with publicly traded companies in the same or similar industry or line of business which are subject to similar risks.  In theory, an equity investment in the guideline companies could represent an alternative to an investment in the subject company.

Once a suitable population of guideline publicly traded companies has been compiled the subject company is typically compared to that of each of the guideline companies selected in terms of profitability and financial condition.  The business appraiser then determines the share price of each stock as of the specific valuation date and multiplies this share price by the number of shares outstanding as of that date.  This computation results in the market value of equity (“MVE”) for a particular guideline publicly traded company as of a specific date.  The guideline company’s debt as of the valuation date can be added to the MVE to determine that market value of invested capital (“MVIC”).  Utilizing the MVE and MVIC, the business appraiser can determine valuation multiples such as MVIC/Revenue, MVIC to EBITDA and MVE/Net Income.

Due to the fact that the guideline publicly traded company method utilizes spot market prices as of a single date to determine the valuation multiples, it is highly sensitive to the market fluctuations discussed at the beginning of this article.  However, the valuation analyst can apply an adjustment for differences between the growth expectations for the public companies and the subject company.

The guideline publicly traded company method produces a snapshot of what companies in an industry similar to a private company are selling for as of a particular date.  It is important for a business appraiser to utilize his or her judgment and experience to determine whether utilizing stock market information as of the valuation date makes sense based on the specific facts and circumstances of each valuation.  The income approach produces a value indication derived from historical stock market data.  Once again, judgment must be utilized by the business appraiser with regards to the appropriateness of the value indications produced by the income approach.

By understanding the sensitivity of each method to stock market fluctuations, end users of business valuations can better grasp the correlation between changes in the public market and the value of privately held companies. While both the income approach and the guideline publicly traded company method within the market approach rely heavily upon stock market data to determine value indications for privately held companies, they differ greatly in their sensitivity to market volatility.  It is important to note that neither method produces a perfect, unassailable, indication of value for a private company as of a particular moment in time.  Furthermore, the typical marketing time for privately held companies is several months while an investor in the stock market can receive cash within 3 business days.  Thus, private company values are less likely to swing dramatically from day to day due to the inability to transact them in a timely fashion.

By Henry & Horne