Public vs. Private Valuation

Private companies are typically valued at a much lower multiple of earnings. This often causes the exit value of a private company to be significantly undervalued. Why does this occur? The following reasons contribute to this discrepancy:

Market Liquidity
The primary culprit in discrepancy valuations between private and public companies is a difference in liquidity of each security. There is significant difficulty in finding a timely buyer for an investor to sell securities held in a private company. Public company stock can be readily sold on a regulated market which can enable an investor to liquidate (sell) public company stock with much greater efficiency. This decreases the risk to the owner of a public company's stock, and creates greater intrinsic value in a share of public stock.

Profit Measurement
Private firms often seek to minimize taxes, while public firms seek to report maximized earnings in order to increase the value of their public stock. Public companies' multiples are generally calculated from net income, while private company multiples are generally based on pre-tax (and often pre-debt) income. This discrepancy may result in an inaccurate formulation of a private company's valuation.

Difference in Capital Structure
Public companies in the same industry group typically have similar capital structures. This includes the ratio of debt to equity. However, private companies within the same industry may each have a different capital structure. This causes the valuation of a private business to be based upon an "enterprise value". The "enterprise value" is the pre-debt value of a business, rather than the value of the stock. This is one reason why private company multiples are usually based on pre-tax profits and my not be comparable to a price/earnings ratio used to value public companies.

Ability to Raise Capital
Private companies are at a disadvantage in attracting investors to fund new capital projects due to the liquidity problem discussed above. A public company's stock that is traded with regularity offers the investor an easy exit to take profits or cut losses. The value of this liquidity also allows large institutional investors to participate in trading public company stock. When private companies borrow from banks they must pay an interest premium to receive more capital. The higher interest rates place more pressure on private companies to increase cash flows to meet debt servicing requirements.

Family Succession Issues
Private companies often are driven by the sweat and inspiration of a founding C.E.O. But when the interest level, or managerial experience of successive generations is less than optimum, disaster may strike the firm. This potential devaluation process often affects the family's most valuable asset. This devaluation can be limited through a public exit strategy, professional management, and industry specific board. Succession issues can negatively impact long term loyal employees.

Information Gap
Public companies in the United States are subject to stringent reporting regulation promulgated by the SEC, and recently augmented by the Sarbannes-Oxley Act of Congress. Quarterly 10Q reports, Annual 10K reports, and material events must be reported promptly by a public company. In addition, these companies are subject to independent analysis by research firms that choose to cover a public company stock. A private company's financial statements may be unaudited or constructed upon poor accounting practices. A lack of transparency in the corporate and financial history of the company contributes to a lower valuation of private companies due to unknown factors.