The public stock markets are large, transparent, and liquid. Minority shares of thousands of public companies trade on a daily basis providing visible evidence of consensus pricing for each of them. At the end of the first quarter this year, the S&P 500 Index had a market capitalization of $18.8 trillion. That’s a lot of market capitalization. Shareholders of private companies do not enjoy the same level of financial transparency. In this post, we discuss the key differences between the public and private markets and the importance of regular valuations.
Information About Value
Consider one public company, Apple (AAPL). Its price changes often. There can be observable trends in pricing, depending on the time horizon examined. Today, its market capitalization is $553 billion, its shares are trading in the range of $100 per share, it is selling at a price/earnings multiple of 11.1x, and its current dividend yield rate is 2.3%. All of this information is available with a quick Google search.
This kind of information is available for nearly every public company at the click of a mouse.
With private companies, there is virtually never a market for their minority shares. While there is a market for controlling interests of private companies, that market is rarely accessed by the typical business. Therefore, for most private companies information about value is usually not available for non-shareholders, and often, not even for some shareholders.
The exception may be for companies domiciled in Delaware where, as we learned in an earlier post, shareholders are able to make written requests to examine their books and records under Delaware Code Section 220.
While the public markets provide ongoing information about valuation for public companies, the only way to obtain credible evidence of valuation for private companies is to engage in an appraisal process with a qualified business appraiser. However, many private companies never obtain a business valuation (appraisal) so little is known about value.
We have noted many times that value is a function of expected cash flows, the expected growth of those cash flows, and risk. This functionality works both for public and private businesses.
The board and management of a public company knows that its shares are being valued today based on investor expectations about its future. They also know that the company’s shares will be valued tomorrow, and that dividends and share buybacks will be recorded. Finally, they know that their performance will be judged by the returns they provide for investors.
As a result, public companies face a constant tension between reinvesting in their businesses to finance future growth and providing returns to shareholders, either in the form of dividends or share repurchases. Boards and management of public companies generally desire to provide competitive returns. If they don’t, there is danger of shareholder apathy and declining stock prices. If a company’s shares decline too much, it can become attractive as a takeover target. So the markets provide a certain discipline regarding a focus on returns.
With private companies, value is also expectational in nature. It is just not measured very frequently, or not at all. Nevertheless, value does change over time, even if no one is watching. And returns are being provided – or not – to private company owners, even if they are not recorded. We discussed private company shareholder returns here.
Public companies file regular reports with the Securities and Exchange Commission, which has oversight responsibility for the public markets with the goal of protecting investors. Each company files a Form 10-q for the first three quarters of their fiscal years, and then an annual report, called a Form 10-k, following the end of each fiscal year. The idea behind this quarterly and annual financial reporting is to provide adequate information for investors to make informed decisions regarding their investments in public companies. There are also many other required disclosures when certain events occur.
This public information is readily available from the SEC, where anyone can search and obtain the various filings for any company. Financial information is also aggregated and made available on Google, Yahoo, and numerous other sources.
This information is used by business appraisers when applying the guideline public company method. Appraisers using this method attempt to identify public companies that are sufficiently similar in nature, business, size, and other comparative features to derive valuation multiples that may be applicable to the subject private company. The public securities markets provide active and ongoing evidence regarding the value of private companies.
Private companies have virtually no required public disclosure or shareholder disclosure. A bank may require that a loan client obtain an annual audit, but that is about the extent of sometimes required financial disclosure. Investors in most private companies (sometimes even significant owners) often lack good information about the performance and value of their company.
Who is Looking?
Public companies undergo scrutiny from many sources. There are buy-side analysts working for institutions and sell-side analysts working for investment banking and brokerage companies. There are analysts at thousands of asset management firms who are scouring the markets for investment opportunities. There are technical analysts and there are millions of individual investors, many of whom perform their own analysis of public companies.
Ongoing scrutiny provides an inherent discipline for managements and boards of public companies to report their financial results and prospects and to run their companies for the benefit of their shareholders.
Private companies have no analysts following them. As noted earlier, they provide little or no financial disclosure. What’s more, bank credit analysts will look at the financial performance of private companies they lend to over time, but their interest is from the bank’s viewpoint, and not that of shareholders.
Private Company Valuation Information
Private companies tend to obtain independent valuations in three different circumstances:
- External Requirement to Obtain a Valuation. A business owner may be told by his accountant or tax attorney or business attorney that to accomplish a particular transaction, an appraisal will be required. These appraisals are compliance-oriented in the tax arena and transitionally oriented otherwise.
- Internal Requirement to Obtain a Valuation. Readers of this blog know that I have been advocating a valuation process for buy-sell agreements that entails having a single appraiser provide an initial appraisal and then, annually (or every two years at a minimum) thereafter, to reset the price for the buy-sell agreement. Companies that engage in this program will have an ongoing supply of valuation information that is valuable for examining shareholder returns. The appraiser may also point out risks that, if minimized over time, can enhance value.
- Desire to Obtain a Valuation. Occasionally, business owners will be sufficiently curious or motivated by external events, to obtain an independent appraisal. We have several new clients each year who, when approached by a potential buyer, decide to (or are asked to by an adviser) obtain an appraisal “just to be sure” when an offer comes along.
The public securities markets provide a general context for private company valuation. They provide valuation evidence and a focus on shareholder returns that can be helpful for private companies. So we can summarize as follows:
- The value of private companies, like public companies, is based on expectations regarding cash flow, growth and risk. Value is always future-based.
- Value changes over time for both public and private companies. With private companies value changes based on external and internal conditions, even if no one is looking.
- Since there are virtually no external analysts following most closely held and family businesses, regardless of their size, owners should create the scrutiny with an ongoing valuation process or an occasional look as noted above.
In my experience, now spanning 35 years or so, companies that engage in a regular valuation process tend to be more focused on shareholder returns and shareholder disclosure. They also create a basis, through their ongoing valuation processes, to engage in appropriate transactions and to manage the expectations of their owners regarding performance and value.
Until next time, be well!
My two most recent books are available in an Ownership Transition Bundle. The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers and attorneys.