Equity Valuation【Reading 43】Sample private, companies, 2012

invic

An analyst is examining three companies. Given the information below, which of them is most likely to be a private firm?

Firm	Number of Years in Operation	Market Capitalization	Required Return for Common Stock
A	12 years	$1,324.8 million	14.8%
B	4 years	$1,313.9 million	18.3%
C	19 years	$2,231.0 million	16.4%

A) Firm A.

B) Firm C.

C) Firm B.

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The firm most likely to be a private firm is Firm B. Compared to public firms, private firms are less mature (4 years for Firm B), smaller (market cap of B is $1,313.9 million), and have higher required returns (required return for B is 18.3%).

xinchow

That's pretty compliated stuff

tango_gs

Which of the following statements related to the role of valuation standards in valuing private companies is most accurate:

A) No international valuation standards exist; countries generally each have their own standards for valuation.

B) Standards organizations provide technical guidance that ensures homogeneous valuations by those that use their standards.

C) Business appraisers in the U.S. and most other countries are not required to adhere to government-authorized valuation standards.

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In the United States, the Appraisal Foundation is a congressionally authorized provider of standards, however business appraisers are not required to adhere to the standards. Other challenges involved with valuation standards are: there are many different valuation standards; technical guidance on the use of standards is limited; it is difficult to ensure compliance to the standards; and valuation will depend on the definition of value used. (Study Session 12, LOS 43.l)

tango_gs

Which of the following best describes the guidance on the use of private company valuation standards provided by appraisal organizations?

A) Guidance on the use of standards is not provided.

B) Guidance on the use of standards is necessarily limited due to the heterogeneity of valuations.

C) Technical guidance on the use of standards is widespread, as it is provided by both industry and consumer groups.

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One of the challenges involved with the implementation of appraisal standards is that although the organizations provide technical guidance on the use of their standards, it is necessarily limited due to the heterogeneity of valuations.

tango_gs

Which of the following best describes the implementation of private company valuation standards?

A) Because most valuation reports are private, it is very difficult for appraisal organizations to ensure compliance to standards.

B) Appraisers voluntarily and periodically submit their reports for review by the local appraisal board.

C) Appraisers are required to periodically submit their reports for review by the local appraisal board.

One of the challenges involved with the implementation of appraisal standards is that because most valuation reports are private, it is very difficult for the organizations to ensure compliance to the standards.

tango_gs

Which of the following best describes the implementation of private company valuation standards?

A) Industry groups mandate compliance.

B) Compliance is usually at the discretion of the appraiser.

C) The federal government mandates compliance.

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One of the challenges involved with the implementation of appraisal standards is that compliance is usually at the discretion of the appraiser because most buyers are still unaware of their existence.

tango_gs

Paul Smith is an analyst performing valuations for Lumber Limited. Smith has been given a project to value Timber Industries, a firm that Lumber Limited is considering acquiring. Smith is aware that a number of characteristics distinguish private and public companies, and that these characteristics must be considered during his process of valuing Timber Industries. A number of issues complicate Smith’s valuation: Timber Industries pays its CEO well below a market-based compensation figure, leases a warehouse at an above-market rate, and owns a vacant office building that is not needed for core operations. Smith is also aware that discounts and premiums based on control and marketability must be considered in his valuation of Timber Industries. Compared to a public company, it is most likely that as a private company Timber Industries will have greater:

A) focus on the short-term.

B) quality and depth of management.

C) concerns related to taxes.

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Private firms may be more concerned with taxes than public firms due to the impact of taxes on private equity owners/managers. Private firms are likely to have lower quality and depth of management, as private firms are likely to be smaller and thus may not be able to attract as many qualified applicants as public firms. Private firms are more likely to focus on the long-term than public companies, since in most private firms, external shareholders have less influence and the firm is able to take a longer-term perspective. (Study Session 12, LOS 43.a)

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Which of the following is the most accurate statement related to estimating the discount rate for Smith’s valuation of Timber Industries:

A) As a private firm, Timber Industries can more easily obtain cheap debt financing than a public firm.

B) Timber Industries should be valued using the WACC for Timber Industries, not the WACC of the acquirer Lumber Limited.

C) It is more straightforward to estimate the discount rate for early stage firm than a mature firm like Timber Industries.

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When acquiring a private firm, some acquirers will incorrectly use their own (lower) cost of capital, rather than the higher rate appropriate for the target, and arrive at a value for the target company that is too high. A private firm may have less access to debt financing than a public firm. It is particularly difficult to estimate the discount rate for firms in an early stage of development. (Study Session 12, LOS 43.g)

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One valuation method that Smith is considering for Timber Industries involves using a growing perpetuity formula to estimate the value of intangible assets, and then adding this value to the values of working capital and fixed assets. This method is most accurately described as the:

A) capitalized cash flow method.

B) free cash flow method.

C) excess earnings method.

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The excess earnings method values tangible and intangible assets separately; this method is useful for small firms and when there are intangible assets to value. In the free cash flow method, a firm is valued by discounting a series of discrete cash flows plus a terminal value. In the capitalized cash flow method, a firm is valued by discounting a single cash flow by the capitalization rate. (Study Session 12, LOS 43.f)

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The asset-based approach to private company valuation that Smith is considering for Timber Industries is most likely to be appropriate in the case of a:

A) firm with strong profits and growth potential.

B) mature company with many intangible assets.

C) finance firm such as a bank.

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The asset-based approach is usually not used for most going concerns, but is appropriate for troubled firms, finance firms, investment companies, firms with few intangible assets, and natural resource firms. It values equity as the asset value of a firm minus the debt value of the firm. (Study Session 12, LOS 43.j)

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In order to estimate normalized earnings for Timber Industries, which of the follow items is most likely to require Smith to make an upward adjustment to SG&A? The fact that Timber Industries:

A) leases a warehouse at an above-market rate.

B) owns a vacant office building that is not needed for core operations.

C) pays its CEO well below a market-based compensation figure.

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Normalized earnings should be calculated by adjusting SG&A as follows: 1) Because the market rate of the CEO’s compensation is higher, SG&A expenses should be increased to reflect a normalized compensation expense. 2) Because the market lease rate is lower, SG&A expenses should be lowered to reflect a normalized lease rate. 3) Because the office building is non-core, SG&A expenses should be reduced accordingly (as should depreciation expense). (Study Session 12, LOS 43.e)

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Which of the following statements related to discounts and premiums to benchmark for Smith’s private company valuation of Timber Industries is most accurate:

A) A control premium should be added when the comparable values are for the sale of an entire company, and the valuation is being done for a minority interest in the target company.

B) A discount for lack of marketability should be applied when the comparables are based on public shares, and the interest in the target company is a minority interest in a private firm.

C) A discount for lack of control should be applied when the comparable company values are for public shares, and the target company valuation is for a controlling interest.

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Discounts for lack of marketability are applied when the comparables are based on highly marketable securities, such as public shares, and the interest in the target company is less marketable, as in the case of a minority interest in a private firm. A discount for lack of control is applied when the comparable values are for the sale of an entire company, and the valuation is being done for a minority interest in the target company. A control premium is added when the comparable company values are for public shares or other minority interests, and the target company valuation is for a controlling interest. (Study Session 12, LOS 43.k)

tango_gs

Assume a minority shareholder holds 10% of a private firm’s equity, with the CEO holding the other 90%. Using normalized earnings, the value of the firm’s equity is estimated at $20 million. The CEO refuses to sell the firm and the minority shareholder cannot sell their interest easily. A discount for lack of marketability (DLOM) of 15% will be applied. A discount for lack of control (DLOC) will also be estimated. Using reported earnings instead of normalized earnings provides an estimated firm equity value of $19 million. Which of the following is closest to the value of the minority shareholder’s equity interest?

A) $1,615,000.

B) $1,700,000.

C) $1,900,000.

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Given these figures, the value of the minority shareholder’s equity interest is:

Firm's equity value	$19,000,000
Minority interest	10%
Value of minority interest without discounts	$1,900,000
minus DLOC of 0%	0
Value of interest if marketable	$1,900,000
minus DLOM of 15%	$285,000
Value of minority interest	$1,615,000

tango_gs

An analyst calculates a control premium of 15% and discount for lack of marketability (DLOM) of 20%. Which of the following is closest to the total discount for valuing minority equity interests in the private firm?

A) 35.0%.

B) 30.4%.

C) 35.7%.

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The discount for lack of control (DLOC) can be backed out of the control premium.
The total discount also uses the DLOM.
Total Discount = 1 − [(1 − DLOC)(1 − DLOM)]
Total Discount = 1 − [(1 − 0.1304)(1 − 0.20)] = 30.4%

tango_gs

Which of the following best describes the estimation of discounts for lack of marketability (DLOM) in private company valuations? The primary advantage of using put prices to estimate the DLOM over the other two methods is:

A) exchange traded put prices are readily available.

B) the Black-Scholes model has been shown to be valid for private firms.

C) the volatility of the firm can be incorporated into the analysis.





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If an interest in a firm cannot be easily sold, a DLOM is applied. The DLOM can be estimated using restricted share versus publicly traded share prices, pre-IPO versus post-IPO prices, and put prices. The advantage of using put prices over the other two DLOM estimation methods is that the estimated risk of the firm can be factored into the option price.