Determining the Value of Private Companies: Beyond DCF and P/E Multiples

The valuation of a private company is a critical process for understanding its true worth, especially in the financial industry. Traditional methods such as Discounted Cash Flow (DCF) and P/E multiples are widely used, but they may not always provide a complete picture. Let's explore alternative methods, focusing on the Dividend Discount Model (DDM), and their suitability for various scenarios.

1. Discounted Cash Flow (DCF) Method

The DCF method is a comprehensive approach that estimates the value of a company by considering all expected future cash flows. It involves projecting Free Cash Flow (FCF), which is the cash available to all investors, after accounting for necessary reinvestments. The formula for DCF is:

#39;Equity Value ( frac{FCF_{current}}{(1 K_e)^{1}} frac{FCF_{next}}{(1 K_e)^{2}} frac{FCF_{perpetuity}}{(1 K_e)^{10} cdot (1 text{PGR})} )#39;

Where Ke is the cost of equity, and PGR is the perpetual growth rate. The FCF and PGR are crucial inputs that require detailed projections and realistic assumptions.

2. Dividend Discount Model (DDM)

The Dividend Discount Model is a simpler approach compared to DCF, primarily used for companies that pay dividends. It focuses on predicting Net Income and estimating a future payout ratio, which is the portion of Net Income distributed to shareholders each year. This method is particularly useful for:

Banks and Financial Services Firms (BFS): In these sectors, changes in Operating Working Capital, Capital Expenditures (CAPEX), and Depreciation are negligible, making Net Income a strong indicator. Debt is often more of a raw material, leading to the use of Dividends as the best observable cash flow. Companies in Established Stages: For stable, mature companies, DDM provides a straightforward valuation based on realistic assumptions. However, it is not suitable for early-stage or high-growth companies where detailed future projections are challenging.

3. Relative Valuation

Relative valuation is an alternative approach that leverages market data to value an unlisted company. This method involves using comparable multiples from listed companies or similar transactions (MA). For instance, the Enterprise Value (EV) multiple based on Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) TTM is highly correlated with the firm's total value. Here's an example using Pereira Properties, a Brazilian commercial real estate company:

Example Calculation for Pereira Properties:

EV Market Cap - Net Debt EBITDA TTM R 6,500 million EV/EBITDA TTM median from peers 1.545x EV EBITDA TTM * EV/EBITDA TTM R 10,041.1 million Equity Value EV - Net Debt R 9,196.1 million

It is crucial to consider the following factors that can affect valuation multiples:

Expected growth rates Return on Invested Capital (ROIC) or Return on Equity (ROE) Risk factors such as volatility of stock returns and earnings Macroeconomic indicators like interest rates, country risk, and inflation

For a more accurate analysis, conduct regression analysis to determine the appropriate multiple based on the firm's specific characteristics.

4. Practical Examples and Methods

Example 1: Valuing Pereira Properties

For Pereira Properties, a Brazilian commercial real estate company, the EV/EBITDA TTM multiple was calculated using peers. The median multiple was used to estimate the firm's Enterprise Value, then adjusted for Net Debt to arrive at the equity value.

Example 2: Banks and Financial Services Firms

Banks and Financial Services Firms (BFS) can use Net Income as a reliable indicator of potential dividends and reinvestments. Debt is often treated as a raw material, making Dividends the primary observable cash flow. For instance, a scenario where the Payable Dividend Ratio is 25%, and the cost of equity is 9%, along with a 10% growth rate for the next 10 years, can be used to calculate the equity value per share.

Example 3: ROE and Expected Growth

For firms with available shareholder equity data, the Return on Equity (ROE) can be used to estimate future growth:

Example Calculation:

ROE Net Income / Shareholder#39;s Equity Expected Growth ROE * (1 - Payout Ratio) For ROE 12% and Payout Ratio 25%, the expected growth in Net Income 9%

This method is particularly useful for sectors with stable growth, such as banks and financial services firms.

Conclusion

There are various methods to determine the value of a private company, each with its strengths and limitations. While the DCF method provides a comprehensive view, the Dividend Discount Model is more suitable for mature, dividend-paying companies. Relative valuation offers a practical approach by leveraging comparable market data. Understanding the specific characteristics of the company and the industry is key to choosing the right valuation method.