Valuations: 4 things that make private companies different
While Wall Street firms get a lot of publicity (especially when it comes to mergers and acquisitions), most of the 27 million U.S. businesses are privately held. For accountants and others in financial services, that means a multitude of opportunities can arise to use valuations in planning for succession, evaluating capital allocation and developing a company’s overall road map for growth. Indeed, IBISWorld reported that business valuation specifically is a growth area that represents an opportunity for firms that are interested in taking on more valuation clients.
But providing valuations for private companies can be challenging, given the nature of privately held businesses. While private businesses share a number of common characteristics with publicly traded firms, there are some important differences, according to Aswath Damodaran, a professor of finance at Stern School of Business at New York University.
“The principles of valuation remain the same, but there are estimation problems that are unique to private businesses,” writes Damodaran, an expert on valuation who maintains a library of information on valuations on his website.
These estimation problems can change the value of the business by affecting the discount rates, cash flows and expected growth rates used to create the valuation, he says. Here are four major differences of private companies, according to the professor:
1. Private firms, especially those that are not incorporated, operate under looser accounting standards than public companies, making it more difficult to identify what each item in a financial statement includes and to note differences in earnings between firms.
2. The amount of data available on privately held firms is typically less than is available for publicly traded companies, Damodaran says. “For instance, publicly traded firms have to break down operations by business segments in their filings with the SEC, and provide information on revenues and earnings by segment,” he writes. “Private firms do not have to, and usually do not, provide this information.”
3. Unlike publicly traded firms, private companies lack constantly updated prices for equity and historical pricing data. It can also be more difficult to liquidate an equity stake in a private firm than a public one, given the absence of a ready market for private firm equity.
4. Private owners tend to be closely tied to management and often have most of their wealth invested in the firm, Damodaran says. “The absence of separation between the owner and management can result in an intermingling of personal expenses with business expenses, and a failure to differentiate between management salary and dividends (or their equivalent).”
Accountants who work with privately held companies often use benchmark data to assess the future earning potential of a company and to determine how the companies they are evaluating compare to others in a given industry. Learn more about how accountants can estimate a company’s value and how they can provide value to clients in other ways.