How to evaluate a private company, and how is its value affected by public indices?

logo  2 December 2022

Before selling a company, one must go through an appraisal process. The main prerequisite here is the substantiation for the actual price of the organization, which essentially reflects the results achieved in the course of its economic activity.

What should you pay attention to first?

Evaluate the value of your business by several metrics at once. What attracts the analysts’ attention is the current profit, the cost of organizing projects, liquidity, the competitor presence on the market, intangible and tangible assets, as well as the supply and demand balance for the rendered services.

There are also indices calculated with a formula for the weighted average growth rate of stock prices, such as the Value Line Composite Arithmetic Index (which combines 1,700 NYSE and AMEX stocks). The cost of each share in the index is multiplied by a factor corresponding to its stake in the capital of the company that issued it (the so-called “weight”).

A public company’s value directly affects the price of non-public companies, since the former always has a current market price and capitalization. For example: a large public company and a newly formed non-public entity are developing an operating system, but one is traded on the market, and the other is not. There are numerous secondary attributes (sales, revenue, staff numbers, etc.), and you can compare and contrast companies with each other. Based on how they correlate, you can conclude that a non-public company is worth the same as half of a public company.

Among the methods for assessing non-public companies, the following three are the most common and universal:

  • Multiple comparable company trading analysis;
  • Precedent/comparable transaction analysis;
  • Discounted cash flow or “DCF.”

Other, less popular methods include:

  • Gap analysis;
  • Asset valuation;
  • Analysis of invested capital/replacement value;
  • Leveraged buyout (LBO) analysis.

The most accurate but time-consuming method of business valuation is cash flow discounting. In practice, it is only applicable in certain cases. Alternatively, it must be supplemented by a comparative valuation, which has some advantages over other approaches:

  1. Multiplier evaluation — the easiest and fastest method. However, decision-making speed is less critical when evaluating non-public organizations. This advantage mostly concerns security trading.
  2. In market conditions, the appraiser only sometimes has the opportunity to collect enough data to perform a more complex evaluation, leaving comparative assessment as the only way out of this situation. In practice, the need for more information is quite common, for example, when evaluating startups with scarce activity history. This advantage is especially significant in the conditions of the Russian market economy due to the limited amount of information such as long-term historical data.
  3. Estimation based on multiples is relatively objective, as it is based on market indicators. That is why this assessment approach is widely used by the judiciary of Western countries, especially in the United States.
  4. Given that comparative valuation is a relatively simple and fast method, it can be used to verify the results obtained from with more complex valuation methods. In addition, a significant discrepancy between the effects of multiples and discounted cash flow valuations is likely to indicate an error in the more sophisticated method (assuming comparable companies were selected correctly).

Such in-depth analysis is usually more effective, although it takes longer to perform.

How do indices influence the market?

An index helps one understand the overall trend of a market segment without having to evaluate the position of many disparate companies. However, different companies’ stocks grow at varying rates, while some may not change at all. In addition, studying index dynamics helps market participants understand the impact of certain events on quotes. If, for example, electricity prices are on the rise, then it is logical to expect the growth of quotations for all companies that operate in this industry.

The meaning of stock indices reflects the dynamics of the general direction and movement “speed” of stock quotes for companies in a particular sector of the economy or geographical region. The stock index is sometimes used as a barometer of a country’s business activity and investment climate. If the index is growing, investors remain optimistic about the prospects for investing in a particular field or a country as a whole.

Indices are necessary for broker companies, releasing them from the need to perform a lot of additional analytical work. Otherwise, it would only be possible to understand the influence of factors on the stock market. In other words, indices are an essential component for the fast and efficient operation of any stock exchange.

It is widely known that the turnover of shares for significant financial companies influences and reflects the actions of smaller exchanges and companies. Indices are needed to predict the growth dynamics of financial companies in a particular area. This helps investors anticipate the prospects for investing in a specific segment of the economy to make a profit.

Stock price fluctuations for well-known, prominent companies are believed to reflect the trading dynamics in smaller-scale financial tools from the same industry, which is a critical clarification. Industry stock indices are needed to formulate hypotheses regarding the price movements of different companies in the same field, even those that are not included in the particular index. Accordingly, sectoral indices help investors evaluate the prospects for investing in companies of a particular economic sector at a specific point in time.

Determining the exact value of a company is a highly complex process that must take many factors into account, ranging from the organization’s profits over several years to available technical equipment and personnel. It is also necessary to consider the market’s general state and possible risks. All of this may be challenging to calculate on your own, and some analytics can only be performed by enlisting the help of highly trained specialists.