With publicly traded companies, we know the market price of their shares every day. These prices reflect, at each moment in time and every day, the consensus pricing in the markets based on many factors.
Consider one public company, say Google (NASDAQ: GOOG). Its price changes every day. Often, there will be observable trends in the price. We want to buy cheap and sell dear when we invest in public companies.
With private companies, there is no market for shares. Many private companies never obtain a business valuation (or appraisal), and little is known about value.
Why does the price of a public company change or move over time? Stock prices are based on the consensus of investor pricing based on expectations for future cash flow (earnings) and the expected growth of those earnings in relationship with the risks associated with achieving those expectations. The market wants to know if the company is investing in projects that will achieve its cost of capital and grow the business profitably.
With public companies there is a tension between reinvesting in the business for future growth and with returning money to shareholders, either in the form of dividends or stock repurchases or buybacks.
Private company values also change over time, even if no one is watching, i.e., even if there are no appraisals of a business. Private company values are a function of expected cash flows, expected growth, and risk, just like with public companies.
The Securities and Exchange Commission (SEC) mandates financial reporting requirements for all public companies. For example, public companies are required to file (and make public) annual reports (Form 10-Ks) and quarterly reports (Form 10Qs). These reports provide annual and quarterly financial reports (including income statements, balance sheets, cash flow statements, retained earnings statements and footnote disclosure).
Management of each public company is responsible for explaining their company’s performance in these documents, as well as highlighting risks, like customer concentrations, faced by shareholders or potential investors.
In addition, they must file annual proxy statements (Form DEF 14As), which inform shareholders about coming issues to be voted on at a company’s annual meeting of shareholders. There are a number of other required disclosure documents, as well.
Shareholders of public companies have access to enormous amounts of information about each company that provides, at least in concept, sufficient information for investors to make informed investment decisions.
Private companies have virtually no required public disclosure, or even shareholder disclosure. A bank may require that a lending client obtain an annual audit, but that is about the extent of required financial disclosure. Investors in most private companies, sometimes even significant owners, often lack good information about their company’s performance and value.
Many sets of eyes are looking at most public companies. There are a variety of analysts who look at the public markets and individual companies from differing perspectives. They each develop what are called analysts’ expectations for individual companies. Various analysts make forecasts for expected EPS (earnings per share), EBITDA (earnings before interest, taxes, depreciation and amortization), and even revenues and margins.
The analysts don’t always agree on the expectations for individual public companies, but their constant looking and comparing create a flow of expectations that collectively set market prices each day. Types of analysts include:
- Sell-side analysts. Analysts working for investment banking firms follow companies, usually along industry lines, and make recommendations to their firms’ investors about the expected future performance of individual stocks. They sell investment ideas to institutional investors and other investors with large pools of money to invest. Some firms sell their research and recommendations to retail investors.
- Buy-side analysts. Large institutions hire analysts to follow stocks and industries. They sometimes perform independent research and often interact with sell-side analysts.
- Analysts at asset management firms. Asset managers pool funds for investment. They have analysts who follow individual companies and industries, as well. They are buy-side analysts as well, but I think of them differently than institutional investors.
- Technical analysts. There are analysts who follow macroeconomic trends and/or technical aspects of the trading in individual stocks.
- Individual investors as analysts. There are millions of individual investors who own some stock of public companies. They do their own research, which may or may not be sophisticated, but they do have access to enormous amounts of information to assist them.
All these analysts are looking for ideas that might give them or their funds an edge in a world where thousands of analysts are looking at 8,000 or so public companies with sufficient market capitalizations to be of interest. They look at information on individual companies in the context of industry conditions for various industries, the national economy, the availability of financing, and other external factors.
There is another result of all of this attention being paid to public companies. There is an inherent discipline imposed on public companies to report their financial results and prospects and to run their companies for the benefit of shareholders. Managements who fail to focus on shareholders are increasingly the targets of activist investors, or investors who purchase significant stock with the intent to influence managements and boards to focus on shareholder returns.
Private companies have no analysts following them. As noted, they provide little or no financial disclosure to shareholders or to anyone else. Bank credit analyst do look at the financial performance over time of significant lending customers of their banks. But that’s about it.
Public company investors tend to invest in portfolios of stocks following a concept known as diversification. They also invest in other asset classes (bonds, timber, real estate, and others) following a concept known as asset allocation, but that’s not a topic for us today.
The basic idea of diversification is that bad things happen to some companies, and great things happen to others. For a portfolio of stocks, investors should be able to achieve an appropriate risk-adjusted return for particular portfolios of stocks.
We have learned a few things from this look at public companies:
- Value is based on expectations for future cash flows, growth in those cash flows, and the risks associated with achieving them. In other words, value is based on future expectations.
- Thousands of analysts look at the public markets and individual companies from their various perspectives, in addition to millions of individual investors. Collectively, they make the markets for individual public company stocks, and create form of management discipline for public companies.
- Value changes over time because of changes in investor expectations based on the national economy, the availability of financing, industry conditions, and what goes on with individual companies.
Now, let’s take one final look at private companies in the context of this overview discussion of the context of public company pricing and valuation in the public markets.
The value of private companies, like that of public companies, is based on expectations regarding cash flow, growth and risk. Value is always future-based.
There are virtually no external analysts following or even looking at most closely held and family businesses, regardless of their size. Quite large private companies will get attention from their banks and also from investment banks who hope to do business with them in the future. However, other than bank credit analysts who look at loan customer performance, there is little following and virtually no externally imposed management discipline.
Value changes for private companies over time and with changes in external and internal conditions, even if no one is watching the change.
We look at the focus on public company valuation for an important reason. When markets are public, there is keen focus on pricing and valuation from many differing viewpoints.
When we think about the value of private companies, we will employ a bit of this public market viewpoint.
- Financial disclosure. Even without SEC-required financial disclosure for private companies, it is a good idea to maintain good financial disclosure. This may mean having an annual audit or review. It may also mean maintaining good operational and financial books and records for management purposes. This will go against the grain for some business owners, but I believe it is a good idea to share financial performance results with all shareholders.
- Analytical attention. Most private companies will simply not have much external analytical attention. That’s why I think that periodic business appraisal is such an important discipline for private companies. Business appraisers look at the same expectations for future cash flows, growth and risk that the public market analysts focus on. I’ll come back to this idea later in the book.
- Value changes over time. The only way to track the pattern of value growth or change over time with a private company is with annual or periodic appraisal. There will never be daily pricing for a private company until the day that one goes public, which is quite rare. If value weren’t so important in the public markets, there would be less attention. But it is important and there is intense focus. Valuation is also important for private companies, because business value now and the expected value in the future form important perspectives for the Business End Games of business owners. For more on this important topic, see my book Unlocking Private Company Wealth.
We have a context within which to think about business value, so in the next posts we will focus on this question:
What is (business) value all about?
We said that value is all about expected cash flow, expected growth and risk above, so let’s look at theses factors. First we’ll define business value in words and then we’ll look at what I call the basic valuation equation.
In the meantime, be well.