What’s the difference between valuing public and private businesses? Are multiples for public companies applicable to small and mid-sized businesses?
It’s helpful to understand the key differences in order to gain a clear understanding of the factors that have the greatest influence on the value of your company.
Most public companies succumb to the fickle nature of the stock market, which is the root cause of nearly every difference outlined in this article. Most factors can be understood through the lens of time. Investors in public companies have a short-term time perspective, whereas owners of private companies have a long-term perspective.
Despite the impact of these factors in the long-term, we cannot deny the pervasive effect of the short-term outlook of the markets on participants’ behavior as we lay out the key differences between the valuation of public and private companies.
The main factors to consider when examining the differences between valuing a private and public company are:
- Time Horizon
- People & Stakeholders
- Consistent Pricing
- Economic Variables
- Financial Statements
- Valuation Methods
This article explores these 18 differences between valuing private and public companies.
Table of Contents
- 18 Differences Between Valuing Public and Private Businesses
- Time Horizon
- People & Stakeholders
- Consistent Pricing
- Economic Variables
- Financial Statements
- Valuation Methods
18 Differences Between Valuing Public and Private Businesses
Public Companies: Public companies must please their investors, who overwhelmingly have a short-term time horizon. When operating on a short-term perspective, many variables will affect the price, and the value of a company will fluctuate on a daily basis as a result of the interplay of these factors. Public companies measure results over a quarterly basis and are under constant pressure to produce consistent results quarter by quarter repeatedly. Many investors have short holding periods and turn over their entire portfolios several times per year. The average holding period of an equity for these investors may be less than a few months. Day traders sometimes hold stocks for minutes or hours before selling. Speculators operate in a similar time frame. This short-term investor perspective requires owners of public companies to manage on a short-term time horizon, and this time perspective must be taken into account when valuing a public company.
Private Companies: Owners of private companies have a long-term time horizon, often measured in decades rather than minutes, hours, days, weeks, months, or quarters. With fewer stakeholders to please, owners of private enterprises are free to focus on long-term objectives rather than inflating short-term objectives, such as boosting quarterly earnings. When valuing a company, you must consider the objectives and timeframe of the company and the impact it may have on earnings. Public companies are prone to manipulate earnings to smooth them out over time, to offer investors a smooth, positive trajectory, whereas private companies seldom attempt to massage the numbers to meet the expectations of a multitude of external stakeholders.
People & Stakeholders
Public Companies: The landscape of participants that exert influence on the value of stocks includes equity analysts working for institutional money managers, lawyers who write prospectuses and annual reports, accounting firms that must exercise judgment when applying accounting principles, mutual funds, hedge funds, pension funds, insurance companies, securities firms, credit rating agencies, independent research firms, investment banks, brokerage houses, and bank trust departments. Also included are institutional investors who invest other people’s money for a fee, such as pension funds, insurance companies, endowments, and corporate retirement plans. This cornucopia of investors and their advisors then comprise a group whose incompatible objectives result in conflicting opinions that lead to rapidly fluctuating market prices. This also makes it necessary for public companies to constantly manage the expectations of a large body of constituents with divergent objectives, time frames, incentives, and perspectives. Yes, manipulating others’ opinions is just as important to a chief executive as understanding game theory is to an investor.
80% of analyst recommendations are to buy. How could this statistical impossibility exist? One word: Incentives. When examining a public company, you must always take into account the incentives of the expert whose opinion you are considering. Regulatory agencies such as the SEC and FINRA do their best to align players’ incentives through the establishment of regulations designed to improve disclosure and the flow of information to investors. Their decisions subsequently influence market prices.
The media further compound the capricious nature of the markets by indiscriminately opining on the value of public companies. The media exerts tremendous influence on stock prices through the dissemination of information that is unregulated and therefore rarely challenged. The Wall Street Journal, The New York Times, Fortune, Business Week, Barron’s, TV, magazines, movies, radio are all deft provocateurs whose primary goal is to attract eyes through seductively designed short stories to attract eyes, which pad the pocketbooks of their consumers. The media’s consumers not only have economic objectives but political objectives as well. Not surprisingly, these free sources of information are the primary source of data for individual investors. Few individual investors read annual reports, which are heavily edited by cadres of sophisticated attorneys, whose primary objective is to eliminate risk through the obfuscation of information rather than the clarification of information. Do you consider news sources to be objective and unbiased? These sources of information comprise the majority of public opinion, and public opinion, in turn, influences the prices of equities.
When investing in the public markets, one must consider the opinions of other investors since their opinions can influence the value of your holdings in the short term. Mastering game theory is a prerequisite to investing in public securities.
Few investors rise above the short-term cacophony of the market to focus on the long-term intrinsic value of companies. As a result, the valuation of public companies depends on the opinion of a medley of players with diverse interests entering and exiting the game at a moment’s notice. In the short term, public company valuation involves analyzing human behavior as much as analyzing the financial performance of a company.
Private Companies: The panorama for private companies is more like the smooth, winding backroads of Switzerland as opposed to the hustle and bustle of Tokyo. Whereas public companies must constantly battle the expectations of a divergent group’s interest, private companies have two key constituents: Their employees and their customers. Governance is simple in a private company with fewer stakeholders to please, relative to the labyrinth of players with conflicting interests in a public company. Incentives are also simple: Make a lot of money and pay little in taxes. You must take the incentives of this web of players with contradictory interests into account when estimating the value of a public company, though no such inclusion is necessary when working with a private company that rarely requires such an analysis.
Public Companies: Common stocks, preferred stocks, participating preferred, convertible preferred, warrants, bonds, calls, puts, options, derivatives, futures, forwards, swaps, gonzos, bowyangs, and bumfuzzles. Just kidding about the last three, but would you know any difference? The types of available equities and their derivatives are overwhelming. When pricing a public company, many of these securities must be taken into account. How many options are outstanding, and what is their impact on valuation? What premium do you place on stock that carries additional voting rights? An understanding of the capitalization of a company is necessary when valuing a public company and is inherently difficult due to the complex nature of public firms.
Private Companies: When an entrepreneur is asked what type of entity they have, their typical response is “the big one.” When asked to clarify — “Do you mean an S or C Corporation?” they respond, “I’m not sure. My accountant said it’s the big one.”
This highlights the issue that the average entrepreneur of a private company doesn’t know the difference between the various capitalization structures of common or preferred stock because their capitalization is likely quite simple, as they hold all stock of their company within their family. Capitalization of a private company is normally uncomplicated since one or two owners hold all stock, and there is only one type of stock — common stock. When valuing a private company, in most cases, you can assume the entity is “the big one” (C Corporation), and the owner holds all equity. Exceptions exist, but they are the minority. Valuing a small, private enterprise is, therefore, simpler than valuing a public enterprise.
Public Companies: Advancements in the sophistication of the valuation of companies began with the publication of Security Analysis by Benjamin Graham and David Dodd in 1934. Prior to the publication of this book, the public markets were highly speculative, and pricing was based on rumors. There was a dearth of available information on publicly held companies. The market was dominated by untrustworthy brokers who sold on hype and preyed on the ignorance of investors. Since time immemorial, most people have operated on fear and greed, and brokers capitalized on this inherent human weakness. Insider trading was rampant.
This all changed with the founding of the SEC in 1934. With the availability of information came advancements in sophistication. Today’s investors in the public markets use an assortment of advanced methods, tools, and software to value a publicly held company. From advanced financial modeling to supercomputers that instantly analyze trading volume and price swings, valuing a public company requires more sophisticated techniques, processes, tools, models, and knowledge to tie it all together into a cohesive framework.
Private Companies: Techniques used to value private companies seem primitive in comparison. The majority of private companies are valued using a multiple of EBITDA. Using this metric requires finesse and an understanding of countless nuances that affect the value of a company. However, the tools to value a private company are few, so the ones that do exist are consistently and widely used when valuing a private company. Exceptions exist, such as when venture capitalists use discounted cash flow (DCF) to value a company, but they are rare.
Public Companies: The public markets are teeming with misaligned incentives. Advisors are incentivized to generate fees. The media is incentivized to create provocative stories in a limited amount of time to increase readership. Most analysts look to others when forming an opinion due to their fear of rebuke if they are wrong and having less to gain if they are right. The analyst may obfuscate any contrarian opinion they proffer in an attempt to cover their tracks if they prove to be wrong. Disincentives to be wrong encourages herd behavior. Herd behavior often can quickly turn viral, and its effects can increase exponentially. When valuing a public company, you must question the motives of the producers of the information or the opinions on which your premise of value is based.
Private Companies: Owners of private companies have skin in the game. Nearly all of their wealth is tied to the value of their company. There is seldom a need to question an owner’s motive when valuing a company as it’s normally the same — to maximize their return. Determining the motives of private company founders is more straightforward, and therefore less effort must be expended to evaluate the parties’ motives.
Public Companies: Speculators affect the price of public equities, especially if the shares are thinly held and traded. Advancements in technical analysis — trade solely based on the price and trading volume of a security — also encourage speculative behavior. Investors sometimes base an investment decision solely on the technical details of a stock, such as trading volume or price swings, while ignoring the fundamentals of a company.
Even if an analyst doesn’t believe in technical analysis, they must take these opinions into account when pricing a stock due to the impact these opinions and behavior will have on price. Sometimes, investments in public equities are made with no understanding of the underlying business or even the industry. Margin buying, also known as purchasing equities on credit, further encourages speculation.
This speculative behavior can influence the value of public companies, and these changes must be accounted for when valuing any public company.
Private Companies: Speculation in private companies comes in the form of private investments raised from family and friends. These private investments have little to no impact on the value of private companies, as the terms of these transactions are private. The speculative investment is usually in the form of an illiquid, long-term investment as opposed to a liquid investment that can be readily traded. Investors in private companies often fail to prepare a buy-sell agreement and are therefore committed to the long-term objectives of ownership without a mechanism for exiting their investment. As a result, speculative behavior has little impact on the value of private companies.
Public Companies: Emotions play a critical role in the public markets. Public markets are inclined to over and understeer in response to investor’s behavior. This behavior quickly becomes viral. Shareholders attempt to influence the price of a stock they own by publicly making their opinion known, in an effort to push the value of the stock up. If this occurs, they can sell the stock later and turn a quick profit.
Herd psychology, game theory, and momentum investing based on trading patterns are all paramount concepts to understanding investors’ behavior in the public markets. In the short term, the behavior of investors can be likened to those playing a game of chess: Knowing what the other guy is thinking is critical to making a sound short-term investment, and the pervasiveness of this mental framework subsequently impacts valuations. One must factor the opinions of others into an appraisal.
Private Companies: Emotions certainly play a role in the operations of a private enterprise, though emotions impact private company prices to a lesser degree. Shareholders are few in most private companies; their investment is illiquid and cannot be openly traded in the marketplace. The emotions of shareholders in private companies will rarely influence the value of their companies.
Public Companies: The SEC was formed in 1934 in response to the market crash of 1929, which was caused by speculation due to a lack of reliable information on public companies. The SEC requires regular disclosure of information, which improves the efficiency and ultimately the trustworthiness of the securities markets. After all, the valuation of any company must be based on sound information. Without accurate information, it becomes impossible to assess the value of a company, and the markets will resort to speculation, rumors, and hype.
The SEC attempted to solve issues caused by a lack of information by mandating disclosure requirements and requiring that all publicly held companies’ financial statements be audited. Prior to the founding of the SEC, institutional investors avoided investing in stocks they considered to be too risky. A study from 1929 showed that 79% of public companies refused to disclose their annual revenue to the public. This lack of disclosure discouraged institutional investors from investing, and all that remained were individual speculators, whose fickle behavior turned viral and ultimately caused the 1929 stock market crash.
Accounting standards also varied wildly prior to 1934. Discrepancies in these standards made comparative analysis an arduous, if not impossible, task. Additional agencies and regulations, such as FINRA, were created with the goal of creating efficient capital markets, which remains a sound social goal for all capitalistic democracies. Capital should smoothly flow into the most deserving industries, and these agencies were designed to facilitate the efficient, smooth movement of capital into industries most likely to take advantage of the capital, thereby creating positive returns for investors.
Information on public companies is now efficiently disseminated to thousands of analysts and others participating in the market the millisecond it becomes available. Information is now the lifeblood of the stock market rather than speculation. Data is simultaneously and instantaneously released to over 100,000 advisors and investors and immediately processed by million-dollar supercomputers. Computers constantly analyze incoming data, and equity analysts produce voluminous reports on companies, industries, and economic forecasts. Moody’s and Standard & Poor’s assign credit ratings to corporate bonds. Numerous other bodies of experts strive to produce, analyze, and classify information the moment it’s produced, thereby facilitating sound investment decisions.
Valuing any company still requires judgment, and this subjective application of judgment causes differences in the opinion of value, even between professionals. This window has narrowed though, with the increasing availability of information on companies, their industries, and the standardization of valuation techniques.
Information on public companies is constantly released, and public companies must now exert significant effort to attempt to control the public’s response to this release of information. These efforts must be taken into account when pricing a stock.
Private Companies: Owners of private companies are under no obligation to disclose information to the public regarding their company’s operations or financial results. As a result, information on private companies is difficult, if not impossible, to access. Analysts must resort to scientific guesses, or estimates, when assessing a comparable company for valuation purposes. This lack of information makes valuing a company especially problematic, given that value is a relative term. Investors will always compare numerous investments to seek the one that will generate the highest return. This is harder to do with private companies where there is no access to information on similar investments to calculate returns.
Public Companies: Managing the public’s opinion is an important role for any C-level executive in a publicly held company, as its stock is priced on a daily basis. Shareholders always know exactly what their shares are worth. Pricing information is also recorded over time, with a detailed history of the value of a company over time also available. An exact price can be calculated on a public company at any point in its public history. This constant pricing mechanism facilitates comparable analysis.
Private Companies: Owners of private companies will only find out what their company is truly worth once — when it is sold. Whereas public companies are valued on a daily basis, there will only be one point in time when an owner of a private company knows its true value. This lack of regular feedback makes valuing private companies less than an exact science.
Public Companies: Public companies are more affected by changes in the macroeconomic environment, such as changes in interest or currency exchange rates, than are privately held companies. If interest rates fall, the value of utility stocks increases. A public company’s sales may be tied to changes in economic metrics — for example, a 2% increase in GDP may lead to a 3.5% increase in consumer goods revenue.
Since the macroeconomic environment rapidly changes, this encourages a focus on a short-term time horizon. Knowledge of the macroeconomic environment is imperative to understand short-term fluctuations in the capital markets.
Private Companies: Whereas a strong economy usually leads to a strong stock market, the current economic environment has less of an influence on the value of private companies. The primary economic variables impacting private company valuations are interest rates and the availability of debt financing, which is primarily dependent on the health of the current economy. A lack of debt financing suppresses M&A activity, and the multiples for private companies decline as a result. An increase in interest rates increases the cost of debt financing, thereby decreasing the prices that can be paid for companies. This is especially true for financial buyers, who are the primary pool of buyers of privately held companies.
Public Companies: Most investors have a minority interest in the ownership of a business, making their return dependent on the opinion of other investors. A minority investment lacks control and is worth less than a controlling interest in a company. When valuing a public company, one must account for the mix of majority vs. minority shareholders and add a control premium to any outstanding majority interests.
Private Companies: Majority owners of private companies have control over the financial and operational performance of their company. As a result, a majority interest is worth more than a minority interest, and a control premium must be applied to the value of a controlling interest. When valuing a private company, you must determine the capitalization of the company and the extent of majority and minority interests along with their impact on control and valuation.
Control is a complex issue when ownership is spread across multiple owners of a private firm, especially if there are multiple classes of stock. For example, if there are three owners — two owning 49% each, and one remaining owner owning a 2% interest — then the holder of the 2% interest holds a swing vote. In this scenario, if the two 49% shareholders are in dispute, the 2% shareholder ultimately decides the issue, so the value of this 2% interest is likely worth much more than on a strict pro-rata basis. These dynamics must be considered when valuing a private company, especially if there are multiple owners of stock or even multiple classes of stock with different voting rights.
Public Companies: The price of public companies is based on earnings expectations. Projecting growth in earnings is difficult enough for an insider, let alone an outsider with little knowledge of internal operations. Projections are prepared using a number of complex techniques, such as extrapolating past results via regression, moving averages, trend lines, or exponential smoothing. A significant portion of a company’s price is based on conjecture of future results and excludes past results. These estimates are heavily dependent on investors’ sentiments regarding the future prospects of the company. A failure to meet quarterly earnings projections only serves to disappoint investors and may dampen their expectations, and have a negative impact on the price of a stock. Public companies are encouraged to make conservative expectations to ensure they are met.
Private Companies: Private companies seldom have external expectations to meet, other than perhaps internal or employee expectations, if the firm practices open-book management and shares financial data with the staff. Absent external expectations, private companies are free to pursue whatever objectives they wish, though most buyers of private companies discount the owner’s expectations (projections), and private companies are valued based on past results, not projected earnings.
Public Companies: A rumor of an acquisition can significantly affect the value of a public company. Rumors can cause wild swings in the price of a stock, regardless of their veracity. The confluence of a juicy rumor, thousands of shareholders, the media, fear, greed, derivatives, and herd behavior conjoined together can cause gyrations in stock prices that become impossible for an executive team to manage. Despite a rational suspicion of a rumor, game theory for short-term investors necessitates responding to the potential impact of any rumors. Valuing a public company, therefore, requires not only an analysis of the facts but also an understanding of the rumors that comprise public opinion regarding a company’s valuation. Even rumors of a company’s or C-level executives’ ethical improprieties can impact a public company’s valuation. Ethical faux pas by CEOs can depress a stock price by 5%, or more, in a single day.
Private Companies: Rumors of acquisitions are regularly spread in industries, but the terms of the transactions are often unknown. The impact of rumors on valuation is less pervasive for private companies than for their public equivalents, though rumors do have an impact to a certain extent.
Public Companies: A body of regulators, including accounting firms, law firms, and credit rating agencies, serve to regulate the financial markets in which public companies operate. These regulations help to create more uniform behavior and produce a consistent flow of information that can be more readily relied upon when valuing a public company. This facilitates an accurate valuation and analysis with comparative companies. This web of regulation increases investors’ confidence in information which forms the basis of most investment decisions.
Private Companies: Regulation of a private company often comes in the form of the owner’s internal compass, gut feelings, and impulses, or lack thereof. There are many different styles of how private companies are capitalized and many different ways to run them, with many hard-working entrepreneurs bootstrapping their company and operating based on gut. Doing so is often necessary in competitive industries that move fast, but this behavior is encouraged by the competitive environment rather than the regulatory environment. There are not a lot of regulations attached to these methods.
Public Companies: Public companies are much more complex than their private counterparts, and valuing such a company is also inherently more difficult. There are many considerations to be taken into account, including:
- Derivatives — options, forwards, futures, swaps, etc.
- Hedge funds, speculation, short selling — estimated to comprise 50% of trading value on the NYSE.
- Alternative investment styles — quantitative analysis, marketing timing, shadow indexing and sector rotation.
- Multiple classes of stock.
Private Companies: “What type of entity do you have?” “The big one.” Yes, the complexity of the public markets pales in comparison to the complexities in the private markets.
Public Companies: The value of public companies is heavily dependent on projections and earnings estimates. Far less emphasis is placed on past results. This incentivizes public executives to manipulate earnings. Executive compensation is also tied to financial performance, giving executives an incentive to increase stated earnings. As a result, the goal of most public companies is to maximize the stated earnings that appear on financial statements.
Wall Street doesn’t respect conservative accounting practices due to shareholders’ preference for consistent, steady growth. Smoothing out earnings becomes a regular part of the job for executives in public companies. These manipulations must be taken into account when valuing a public company. Whereas the financial performance of a public company can appear to be smooth on the surface, there could be an undercurrent of deeper issues brewing beneath that can only be uncovered with a deeper analysis.
Private Companies: The objective of owners of most private firms is to minimize earnings for tax purposes. Owners do not like paying an enormous amount of money in taxes and therefore do everything possible to minimize their tax obligations through excessive deductions or other sophisticated schemes. When valuing a private company, it’s necessary to adjust or normalize the financial statements to determine the true earnings of the company.
Public Companies: When valuing a public company, one must consider the impact of globalization. The world economies are interdependent, with 29% of the revenue from S&P 500 companies generated from foreign operations. International trends affect the value of public companies, and at least a rudimentary understanding of the impact of an international presence is necessary when valuing a public company. For example, what would the impact be on Apple’s earnings if China banned the sale of iPhones? Or what would the impact be on earnings if Nike entered a new foreign market? Or what impact would a change in currency exchange rates have on a company’s valuation? Consumer tastes are fickle and can have a tremendous impact on valuation. Predicting consumers’ responses in foreign markets is also difficult but may have a tremendous impact on valuation. Understanding the impact of foreign operations is important when valuing a public company.
Private Companies: Many private companies operate on a local or regional basis. Few operate internationally. Changes in international trade may only affect a private company to the extent of a rise in the price of raw materials or other supplies. An understanding of international business is less important to the valuation of private companies unless the company has foreign operations.
Public Companies: Comparison with similar companies is more straightforward because a public company’s financial statements must be audited. There is still some level of subjectivity within GAAP, but the financial statements of public companies, in general, are more reliable and consistent than their private counterparts. This improves the ability to compare the subject company with other companies when performing a comparable company analysis, which is one of the most commonly used valuation methods. Financial statements do not have to be adjusted or normalized to the extent that financial statements of privately held companies do, improving the ease of comparison further.
The availability of information also improves the ability to analyze comparable companies. Public companies must regularly disclose information to the investing public, and this information is publicly available for anyone who wishes to access it. Overall, these factors make comparing a company to its peers simpler, and the market approach can be more readily relied upon for public companies.
Techniques used to value public companies are also more complex than those used to value private companies. Discounted cash flow (DCF) is a highly complex valuation method more commonly used for public companies than for their private counterparts. DCF is highly reliant on projections, and preparing projections for a public company is more manageable than for a private one. Public companies regularly prepare projections, and investors expect the company to meet them.
Overall, techniques used to value public companies and private companies differ. DCF and comparable transaction analysis are more common when valuing public companies.
Private Companies: Comparable transactions are seldom available for private companies, making the market approach difficult when valuing a company. Owners of private companies are not required to disclose the terms of a transaction publicly, and information on private transactions is seldom available. Buyers are disinclined from reporting the terms of their purchase for fear that other sellers may use this information against them to extract a higher purchase price. As a result, buyers are incentivized to artificially deflate the terms of a transaction. If information on the transaction is reported, it is normally done without disclosing the identity of the subject company, which makes clarifying or verifying the terms nearly impossible.
Additionally, the information submitted to transaction databases is rarely verified. When you are relying on information from a transaction database, consider that the information may be questionable due to the lack of a verification process with private company transactions.
There is also a larger degree of subjectivity in the definition of data used in the private transaction databases. For example, when submitting transaction information to a database, what is meant by EBITDA? Is the transaction database asking for EBITDA or adjusted EBITDA? What if the company 179’d (expensed in one year via a Section 179 deduction) the purchase of a large piece of equipment and did not depreciate it? Would this be added back when calculating EBITDA?
These instructions may be provided by the databases to the contributors, but the databases heavily depend on the efforts, knowledge, and goodwill of those submitting the data. The same can be said of public company transaction data, though more experts are involved in larger transactions, standards are applied more consistently, and there are more experts willing to dispute data if it’s incorrect. Comparative information is scarce when attempting to value a private company, making comparative analysis inherently difficult.
The financial statements of private companies must also be adjusted or normalized before valuation methods can be applied, and this process is subjective. Additionally, owners of private companies are not required to have their financial statements audited, and there is more significant variation in accounting practices between small firms.
Methods used to value a private company can be boiled down to one: A multiple of earnings. When discussing the acquisition of a company, nearly every buyer talks in terms of multiples. A multiple of EBITDA is by far the most common method for valuing a private company. Few use DCF when valuing a private company.
|Analysis of the overall factors that influence the sub-factors in the valuation of publicly held companies|
|Factor||Time Horizon||Increases Complexity||More Information|
|People & Stakeholders||✓||✓|
In summary, nearly all of the factors above can be boiled down to the following macro-factors:
- Time Horizon: Investors in public companies have a shorter time horizon than private companies.
- Increased Complexity: Investments in public companies are more complex than investments in private companies.
- Availability of Information: More information is available on public companies than on private companies.