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The art and science of valuing unquoted companies

The art and science of valuing unquoted companies

Valuing early-stage companies is complicated. Consultancy firm McKinsey's latest book about company valuations is an overwhelming 896 pages long.

For a shorter read, you can pore through the 70 pages of the latest International Private Equity and Venture Capital (IPEV) valuation guidelines, widely adhered to by many investment managers in the venture capital or enterprise investment scheme space.

Of course, valuing quoted companies is also a highly specialist skill. But large companies face less risk and volatility than start-ups.

This makes it easier to make predictions about their future performance, and therefore easier to arrive at an estimate of their current value. 

Furthermore, a quoted company’s current market capitalisation gives an immediate indication of its perceived value.

As a result, many everyday investors tend not to think too deeply about the complex issues that ultimately determine a business’s share price.

Similarly, most people who invest in unquoted companies will not feel the need to become experts in start-up and early-stage valuation methodologies.

But, nevertheless, there are some key points that are worth being aware of.  

Understand the model

‘Fair value’ is not the same as ‘expected return’.

Many investment firms such as venture capital managers, provide investors with statements possibly twice or four times a year, showing the value of the shares in their portfolio.

To do this, they are guided by the central premise of the IPEV guidelines, defining ‘fair value’ as the price that would be received ‘in an orderly transaction between market participants at the measurement date’.

This might seem obvious. But it’s important to stress that there is often almost no relationship between the value shown on statements and the value that is expected to be achieved when they eventually sell the shares.

For example, at Vala Capital, if we hope to sell a company five years from now, then our estimation of the company’s current value is of only academic interest, particularly since the shares are illiquid.

A KPMG commentary recently said: “Is the value a true reflection of what a willing buyer would pay (is it too much)? But equally, is it a true reflection of what a willing seller would accept? (Quite possibly it will look too low). No amount of science and mathematics can get away from this critical assessment.”

Valuations are inherently subjective

The Discounted Cash Flow (DCF) valuation method will often be used as part of the valuation process at the point that shares are purchased, but it is less common to rely on DCF when producing interim valuations. 

DCF involves building a financial model that projects the expected cash flows of a business into the future.

Those cash flows (including a prediction of an eventual future sale price) are then added together, before applying a discount rate to adjust for the level of risk and uncertainty faced.