Business valuation professionals routinely rely on public stock market data when valuing private businesses. However, experts also recognize the key differences between public and private companies and adjust their analyses to generate reliable and defensible value conclusions.

Comparing apples to oranges

The New York Stock Exchange and other public markets provide readily available, objective pricing information. Similar data for closely held businesses is much more limited. Proprietary merger and acquisition (M&A) databases contain only a fraction of all private company transactions, and the details aren’t as robust as those published for public companies. As a result, valuators often use public stock data as a starting point when valuing closely held businesses.

For instance, the guideline public company method bases a private company’s value on the stock prices of similar public companies. Alternatively, under the discounted cash flow method, a valuator uses public stock returns as the foundation for a private company’s cost of capital.

Identifying the differences

In general, public companies tend to trade at higher price multiples (or, conversely, pay investors lower percentage returns) than their private counterparts. However, there may be exceptions, depending on the subject company’s size, growth prospects and industry factors.

The primary reason for this discrepancy is that private companies are typically riskier ventures. Public companies generally have greater resources, more professional management, more stringent regulatory oversight and more diversified product offerings than private companies. Public markets also provide greater liquidity — or opportunities to trade securities issued by the company — which investors desire.

Another reason for the discrepancy relates to management’s objective in reporting income. Public companies are generally focused on reporting earnings that meet investors’ expectations. By comparison, private companies may try to lower taxable income (for example, by deferring revenue and accelerating expenses) to optimize their tax outcomes.

Reconciling the differences

Because of these differences, direct comparisons between public and private companies can be difficult or misleading. But there are ways valuators can adjust their analyses to make public market data more relevant to private companies. Common examples include:

• Normalizing the subject company’s financial statements for discretionary and nonrecurring items,
• Adjusting market-based pricing multiples for company-specific risks, and
• Incorporating a company-specific risk premium into the cost of capital.

Valuators might also consider supplementing their analyses with other sources of information, such as industry rules of thumb or private transaction databases. In some cases, valuators may place greater reliance on private transaction data to corroborate conclusions derived from public market inputs.

Keep in mind that the use of public stock market data generally results in a noncontrolling, marketable basis of value. Because private company stocks aren’t actively traded, a valuator may need to apply a discount for lack of marketability (or liquidity) when using public market data to value an interest in a private company. Additionally, when using public market data to estimate a controlling interest in a private company, the valuator should consider whether a control premium or other subjective adjustments may be warranted.

(This is Blog Post #1913)