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All of the principles that we have developed for valuation apply to private
companies as well. In other words, the value of a private company is the present value of
the expected cashflows that you would expect that company to generate over time,
discounted back at a rate that reflects the riskiness of the cashflows. The differences that
exist are primarily in the estimation of the cashflows and the discount rates:
- When estimating cashflows, we should keep in mind that while accounting standards
may not be adhered to consistently in publicly traded firms, they can diverge
dramatically in private firms. In small, private businesses, we should reconstruct
financial statements rather than trust the earnings numbers that are reported. There are



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also two common problems that arise in private firm accounting that we have to
correct for. The first is the failure on the part of many owners to attach a cost to the
time that they spend running their businesses. Thus, the owner of a store who spends
most of every day stocking the store shelves, manning the cash register and
completing the accounting will often not show a salary associated with these activities
in her income statement, resulting in overstated earnings. The second is the
intermingling of personal and business expenses that is endemic in many private
businesses. When re-estimating earnings, we have to strip the personal expenses out
of the analysis.
- When estimating discount rates for publicly traded firms, we hewed to two basic
principles. With equity, we argued that the only risk that matters is the risk that
cannot be diversified away by marginal investors, who we assumed were well
diversified. With debt, the cost of debt was based upon a bond rating and the default
spread associated with that rating. With private firms, both these assumptions will
come under assault. First, the owner of a private business is almost never diversified
and has his or her entire wealth often tied up in the firm™s assets. That is why we
developed the concept of a total beta for private firms in chapter 4, where we scaled
the beta of the firm up to reflect all risk and not just non-diversifiable risk. Second,
private businesses usually have to borrow from the local bank and do not have the
luxury of accessing the bond market. Consequently, they may well find themselves
facing a higher cost of debt than otherwise similar publicly traded firms.
- The final issue relates back to terminal value. With publicly traded firms, we assume
that firms have infinite lives and use this assumption, in conjunction with stable
growth, to estimate a terminal value. Private businesses, especially smaller ones,
often have finite lives since they are much more dependent upon the owner/founder
for their existence.
With more conservative estimates of cashflows, higher discount rates to reflect the
exposure to total risk and finite life assumptions, it should come as no surprise that the
values we attach to private firms are lower than those that we would attach to otherwise
similar publicly traded firms. This also suggests that private firms that have the option of




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becoming publicly traded will generally succumb to that temptation even though the
owners might not like the oversight and loss of control that comes with this transition.

Illustration 12.12: Valuing a Private Business: Bookscape
To value Bookscape, we will use the operating income of $2 million that the firm
had in its most recent year as a starting point. Adjusting for the operating lease
commitments that the firm has, we arrive at an adjusted operating income of $2,368.88
million.33 To estimate the cost of capital, we draw on the estimates of total beta and the
assumption that the firm™s debt to capital ratio would resemble the industry average of
16.90% that we made in chapter 4 (see illustration 4.16):
Cost of capital = Cost of equity (D/(D+E)) + After-tax cost of debt (D/(D+E))
= 13.93% (.831) + 5.50% (1-.4) (.169) = .1214 or 12.14%
The total beta for Bookscape is 2.06 and we will continue to use the 40% tax rate for the
firm.
In chapter 5, we estimated a return on capital for Bookscape of 12.68% and we
will assume that the firm will continue to generate this return on capital for the next 40
years, while growing its earnings at 4% a year. The resulting reinvestment rate is 31.54%:
Reinvestment rate = Growth rate/ Return on capital = 4%/12.68% = 31.54%
The present value of the cashflows, assuming perpetual growth, can be computed as
follows:
Value of operating assets = 2,368.88 (1-.40)(1-.3154)/(.1214-.04) = $12.483 million
Value of cash holdings = $ 2.500 million
Value of the firm = $ 14.939 million
- Value of debt (operating leases) = $ 6.707 million
Value of equity = $ 8.231 million
If we wanted to be conservative, and assume that the cashflows will continue for only 40
years, the value of the operating assets drops marginally to $12.3 million.
In Practice: Illiquidity Discounts in Private Firm Valuation


33In illustration 4.15, we estimated the present value of the operating lease commitments at Bookscape to
be $6.7 million. To adjust the operating income, we add back the imputed interest expense on this debt,




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If you buy stock in a publicly traded firm and change your mind and decide to
sell, you face modest transactions costs. If you buy a private business and change your
mind, it is far more difficult to reverse your decision. As a consequence, many analysts
valuing private businesses apply an illiquidity discount that ranges from 20 to 40% of the
value to arrive at a final value. While the size of the discount is large, there is surprisingly
little thought that seems to go into the magnitude of the discount. In fact, it is almost
entirely based on studies of restricted stock issued by publicly traded firms. These stock
are placed with investors who are restricted from trading on the stock for 2 years after the
issue and the price on the issue can be compared to the market price of the traded shares
of the company to get a sense of the discount that investors demand for the enforced
illiquidity. Since there are relatively few restricted stock issues, the sample sizes tend to
be small and involve companies that may have other problems raising fresh funds.
While we concede the necessity of an illiquidity discounts in the valuation of
private businesses, the discount should be adjusted to reflect the characteristics of the
firm in question, Other things remaining equal, we would expect smaller firms with less
liquid assets and in poorer financial health to have much larger illiquidity discounts
attached to their values. One way to make this adjustment is to take a deeper look at the
restricted stock issues for which we have data and look at reasons for the differences in
discounts across stocks.34 Another way is to view the bid-ask spread as the illiquidity
discount on publicly traded companies and extend an analysis of the determinants of bid-
ask spreads to come up with a reasonable measure of the bid-ask spread or illiquidity
discount of a private business.35

Value Enhancement
In a discounted cashflow valuation, the value of a firm is the function of four key
inputs “ the cashflows from existing investments, the expected growth rate in these
cashflows for the high growth period, the length of time before the company becomes a



obtained by multiplying the pre-tax cost of borrowing (5.5%) by the present value of the operating leases
(6.7 m))
34 Silber did this in a 1989 study, where he found that the discount tended to be larger for companies with
smaller revenues and negative earnings.
35 See Investment Valuation (John Wiley and Sons) for more details.



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stable growth company and the cost of capital. Put simply, to enhance the value of a firm,
we have to change one or more of these inputs:
a. Increase cashflows from existing assets: There are a number of ways in which we can
increase cashflows from assets. First, we can use assets more efficiently, cutting costs
and improving productivity. If we succeed, we should see higher operating margins
and profits. Second, we can, within the bounds of the law, reduce the taxes we pay on
operating income through good tax planning. Third, we can reduce maintenance
capital expenditures and investments in working capital “ inventory and accounts
receivable “ thus increasing the cash left over after these outflows.
b. Increase the growth rate during the high growth period: Within the structure that we
used in the last section, there are only two ways of increasing growth. We can
reinvest more in internal investments and acquisitions or we can try to earn higher
returns on the capital that we invest in new investments. To the extent that we can do
both, we can increase the expected growth rate. One point to keep in mind, though, is
that increasing the reinvestment rate will almost always increase the growth rate but it
will not increase value, if the return on capital on new investments lags the cost of
capital.
c. Increase the length of the high growth period: It is not growth per se that creates
value but excess returns. Since excess returns and the capacity to continue earning
them comes from the competitive advantages possessed by a firm, a firm has to either
create new competitive advantages “ brand name, economies of scale and legal
restrictions on competition all come to mind “ or augment existing ones.
d. Reduce the cost of capital: In chapter 8, we considered how changing the mix of debt
and equity may reduce the cost of capital, and in chapter 9, we considered how
matching your debt to your assets can reduce your default risk and reduce your
overall cost of financing. Holding all else constant, reducing the cost of capital will
increase firm value.
Which one of these four approaches you choose will depend upon where the firm you are
analyzing or advising is in its growth cycle. For large mature firms, with little or no
growth potential, it is cashflows from existing assets and the cost of capital that offer the
most promise for value enhancement. For smaller, risky, high growth firms, it is likely to


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be changing the growth rate and the growth period that generate the biggest increases in
value.

Illustration 12.13: Value Enhancement at Disney
In illustration 12.11, we valued Disney at $11.14 a share. In the process, though,
we assumed that there would be no significant improvement in the return on capital that
Disney earns on its existing assets, which at 4.42% is well below the cost of capital of
8.59%. To examine how much the value per share could be enhanced at Disney if it were
run differently, we made the following changes:
- We assumed that the current after-tax operating income would increase to $3,417
million, which would be 8.59% of the book value of capital. This, in effect, would
ensure that existing investments do not destroy value.
- We also assumed that the return on capital on new investments would increase to
15% from the 12% used in the status quo valuation. This is closer to the return that
Disney used to make prior to its acquisition of Capital Cities. We kept the
reinvestment rate unchanged at 53.18%. The resulting growth rate in operating
income (for the first 5 years) is 7.98% a year.
- We assumed that the firm would increase its debt ratio immediately to 30%, which is
its current optimal debt ratio (from chapter 8). As a result the cost of capital will drop
to 8.40%.
Keeping the assumptions about stable growth unchanged, we estimate significantly
higher cashflows for the firm for the high growth period in table 12.6.
Table 12.6: Expected Free Cashflows to the Firm- Disney
Cost
Expected EBIT Reinvestment of PV of
Year Growth EBIT (1-t) Rate Reinvestment FCFF FCFF
capital
Current $5,327
1 7.98 % $5,752 $3,606 53.18 % $1,918 $1,688 8.40 % $1,558
2 7.98 % $6,211 $3,894 53.18 % $2,071 $1,823 8.40 % $1,551
3 7.98 % $6,706 $4,205 53.18 % $2,236 $1,969 8.40 % $1,545
4 7.98 % $7,241 $4,540 53.18 % $2,414 $2,126 8.40 % $1,539
5 7.98 % $7,819 $4,902 53.18 % $2,607 $2,295 8.40 % $1,533
6 7.18 % $8,380 $5,254 50.54 % $2,656 $2,599 8.16 % $1,605
7 6.39 % $8,915 $5,590 47.91 % $2,678 $2,912 7.91 % $1,667
8 5.59 % $9,414 $5,902 45.27 % $2,672 $3,230 7.66 % $1,717



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9 4.80 % $9,865 $6,185 42.64 % $2,637 $3,548 7.41 % $1,756
10 4.00 % $10,260 $6,433 40.00 % $2,573 $3,860 7.16 % $1,783

The terminal value is also pushed up, as a result of the higher growth in the high growth
period:
Terminal value = FCFF11/(Cost of capital “ g) = 6433 (1.04)/(.0716-.04) = $126,967 mil
The value of the firm and the value per share can now be estimated:
Present Value of FCFF in high growth phase = $16,254.91
+ Present Value of Terminal Value of Firm = $58,645.39
+ Value of Cash, Marketable Securities & Non-operating assets = $3,432.00
Value of Firm = $78,332.30
- Market Value of outstanding debt = $14,648.80
- Value of Equity in Options = $1,334.67
Value of Equity in Common Stock = $62,348.84
Market Value of Equity/share = $30.45
Disney™s value per share increases from $11.14 per share in illustration 12.11 to $30.45 a
share, when we make the changes to the way it is managed.36
In Practice: The Value of Control
The notion that control is worth 15% or 20% or some fixed percent of every
firm™s value is deeply embedded in valuation practice and it is not true. The value of
control is the difference between two values “ the value of the firm run by its existing
management (status quo) and the value of the same firm run optimally.
Value of control = Optimal value for firm “ Status quo value
Thus, a firm that takes poor investments and funds them with a sub-optimal mix of debt
and equity will be worth more if it takes better investments and funds them with the right
mix of debt and equity. In general, the worse managed a firm is the greater the value of
control. This view of the world has wide ramifications in corporate finance and valuation:
- In a hostile acquisition, which is usually motivated by the desire to change the way
that a firm is run, you should be willing to pay a premium that at best is equal to the


36 You may wonder why the dollar debt does not change even though the firm is moving to a 30% debt
raito. In reality, it will increase but the number of shares will decrease when Disney recapitalizes. The net
effect is that the value per share will be close to our estimated value.


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value of control. You would rather pay less, to preserve some of the benefits for
yourself (rather than give them to target company stockholders).
- In companies with voting and non-voting shares, the difference in value should be a
function of the value of control. If the value of control is high and there is a high
likelihood of control changing, the value of the voting shares will increase relative to
non-voting shares.
In the Disney valuation above, the value of control can be estimated by comparing the
value of Disney, run optimally, with the status quo valuation done earlier in the chapter.
Value of controlDisney = Optimal value “ Status quo value = $30.45 - $11.14 = $19.31
The fact that Disney trades at $26.91 can be an indication that the market thinks that there
will be significant changes in the way the firm is run in the near future, though it is
unclear whether these changes will occur voluntarily or through hostile actions.


Relative Valuation
In discounted cash flow valuation, the objective is to find the value of assets,
given their cash flow, growth and risk characteristics. In relative valuation, the objective
is to value assets, based upon how similar assets are currently priced in the market. In this
section, we consider why and how asset prices have to be standardized before being
compared to similar assets, and how to control for differences across comparable firms.

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