Valuation – Public companies versus privately held businesses – a few issues
There are a number of factors that are considered differently in the valuation of privately held vs. public ( ASX listed ) companies—even those that are in the same industry—making a direct comparison for valuation purposes difficult. In some cases, it’s like comparing apples to oranges. Following is a list of some of the issues that may result in differences between the valuations of public and private businesses:
1. Market liquidity
A lack of market liquidity is usually the biggest factor contributing to a discount in the value of companies. With public companies, you can, if you choose, switch your investment to the stock of a different public company on a daily (if not more frequent) basis. The stock of privately held businesses, however, is more difficult to sell quickly, making the value drop accordingly.
2. Profit measurement
While private companies seek mostly to minimise taxes and provide an effective ( though not always easy to follow ) income stream to the owners, public companies seek to maximize earnings for shareholder reporting purposes. Therefore, the profitability of a private business may require restatement in order for it to be directly comparable to that of a public business. In addition, public-company multiples are generally calculated from net income (after taxes), while private-company multiples are often based on pre-tax (and many times, pre-debt) income. This discrepancy can result in an inaccurate formula for the valuation of a private company.
3. Capitalisation/capital structure
Public companies within a specific industry generally maintain capital structures (debt/equity mixes) that are fairly similar. That means the relative price/earnings ratios (where earnings include the servicing of debt) are usually comparable. Private companies within the same industry, however, can vary widely in capital structure. The valuation of a privately held business is therefore frequently based on “enterprise value,” or the pre-debt value of a business rather than the value of the stock of the business, like public companies. This is another reason why private-company multiples are generally based on pre-tax profits and may not be directly comparable to the price/earnings ratio of public companies.
4. Risk profile
Public companies usually provide an assurance of continuing operations above that of smaller, privately held businesses. Downturns in the economy or a change in the environment (such as an increase in competition or regulatory changes) often have a greater impact on private business than public businesses in terms of performance and market positioning. That higher risk may result in a discount in value for private businesses.
5. Differences in operations
It is often difficult to find a public company operating in the same niches as private businesses. Public companies typically have operations spanning a broader range of products and services than do private companies. In addition, even if the products and services are the same, the revenue mix is often different.
6. Operational control
Although private companies are more likely to receive valuation discounts than public companies, there is at least one area where they may receive a value premium. While the sale of a private company usually results in the purchase of the controlling interest in the business, ownership of public-company shares generally consists of a minority-share ownership—which may be construed to be less valuable than a controlling-interest position.
Given all these examples, you can see how the valuation of private companies is complex and often cannot be determined through the direct application of public company price/earnings ratios.