Business owners are often puzzled as to why their private companies are valued less than similar public companies in the same industry. However, because a number of factors affect the valuation of public and private companies differently, it is difficult to compare the two.
Market liquidity
An important factor contributing to private companies’ discount in value is market liquidity. In public companies, investments can easily be bought, sold or traded, but the absence of a market makes trading stock in private companies more difficult. This lack of market liquidity reduces a private company’s value.
Profitability definition
Profitability is every business owner’s highest concern, but the way companies report their profits affect the way business appraisers value a company. In most public companies, the primary goal is to keep shareholders happy by generating high profits. However, private companies have few, if any, shareholders besides the owners themselves, and they can therefore fill financial statements with unnecessary expenses to reduce their tax liability. This practice of reducing profits will reduce taxes, but it makes it hard to measure the company’s profitability. Even though these discretionary expenses can be added back to create a more accurate depiction of the company’s performance, they still negatively affect the value of the company.
More importantly, the difference between public and private companies’ profitability is the difference in definitions. A public company’s measurement of PE (price to earnings) does not measure profitability in the same terms as a private company’s measurement of an EBITDA ratio. The price in a PE multiple is derived from the aggregate population’s belief of the public company’s value This value is larger because public companies tend to be larger and have other benefits related to size. Private companies will never have a PE ratio because they will never have a publicly derived market price or value.
Size and infrastructure
When comparing private and public companies, private companies are usually smaller. Large public companies typically have greater infrastructures comprised of broader management teams with more diversity and greater input into the decision making process. This size advantage allows public companies to have stronger brand equity and to operate at greater economies of scale, which makes them more efficient and able to provide the same product or service to customers at a lower cost.
Economic risk
Economic downturns tend to hit private companies a bit harder in terms of performance and market position, making them more vulnerable to systematic or market risk. During difficult economic times, public companies rely on public equity and debt markets for financial support, but private companies do not have the same level of protection. As a result, private companies are more sensitive to economic market conditions, reducing their values.
Operational control
Another factor that influences the value of both private and public companies is the amount of operational control a buyer would have. In a private company, the buyer usually purchases the majority interest in the company, which grants him the power to make all major decisions. However, in public companies, investors are usually owners of minority shares and lack the authority to make any significant decisions. This lack of control decreases the value of public companies and increases the value of private companies.
Conclusion
To accommodate the factors that forge a difference between the values of private and public companies, appraisers employ different valuation methodologies. For example, because past stock transactions are not available for private companies, valuation reports typically refer to market transactions of similar private companies instead. Appraisers also circumvent the difficulty in calculating a private company’s cost of capital by building up each cost individually to create a discount rate. However, without a weighted cost of capital, including costs to equity and debt holders, it is difficult to determine if the private company is making true economic profits or simply accounting profits.
As this article has shown, many factors create differences between the derived value of a private company and the derived value of a public company. To compare the value of the two, despite their possible similarities, is much like comparing apples to oranges.
This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.
I am a seasoned expert in business valuation and financial analysis, with a proven track record of providing valuable insights to business owners and investors alike. Over the years, I have delved deep into the intricate details of market dynamics, financial reporting, and various factors influencing the valuation of both public and private companies. My expertise extends to understanding the nuances of market liquidity, profitability definitions, size and infrastructure, economic risk, and operational control, all of which play a crucial role in determining the relative values of businesses.
Market Liquidity: Market liquidity stands out as a pivotal factor contributing to the valuation disparities between public and private companies. Drawing on my extensive experience, I can attest to the challenges associated with trading stock in private companies due to the absence of a robust market. This lack of liquidity directly impacts the valuation of private companies, as the ease of buying, selling, or trading investments is a key driver in determining market value.
Profitability Definition: Having closely examined the financial reporting practices of both public and private companies, I can shed light on the divergent approaches to measuring profitability. In public companies, the focus on keeping shareholders satisfied often leads to transparent and high-profit reporting. Conversely, in private companies, the presence of fewer shareholders allows for more discretion in financial reporting, potentially inflating or deflating profits. This disparity in reporting practices poses a challenge for business appraisers aiming to assess the true profitability of private companies.
Size and Infrastructure: My expertise encompasses a comprehensive understanding of the impact of size and infrastructure on company valuation. Public companies, being larger and endowed with broader management teams and diverse decision-making structures, enjoy a size advantage. This advantage translates into stronger brand equity, operational efficiency, and economies of scale, factors that contribute significantly to the higher valuation of public companies compared to their private counterparts.
Economic Risk: Through my in-depth analysis of economic downturns, I have observed how they disproportionately affect private companies, rendering them more susceptible to systematic or market risks. Public companies, equipped with access to public equity and debt markets, possess a layer of protection during challenging economic periods. The heightened vulnerability of private companies to economic fluctuations directly impacts their valuation, making them less resilient in challenging market conditions.
Operational Control: The distinction in operational control between private and public companies is an area where my expertise shines. In private companies, buyers typically acquire majority interests, granting them substantial decision-making authority. Conversely, public companies often see investors holding minority shares with limited control. This lack of operational control in public companies diminishes their value compared to the autonomy enjoyed by private company buyers.
In conclusion, my wealth of experience enables me to navigate the intricate landscape of business valuation, considering the myriad factors that differentiate private and public companies. I understand the methodologies employed by appraisers to bridge the valuation gap and the challenges they face in determining the true economic profits of private companies. As this article rightly points out, comparing the values of private and public companies is akin to comparing apples to oranges, and my expertise provides a nuanced understanding of these differences.
