Private company valuation

Hello everyone, I have question for practitioners who are involve in valuation of private companies.

I would like to ask, at which day should I value the company using FCFF method?

For example: I have company’s past financial data for 2012-2015 and 9 months of 2016. So using the FCFF method, I will forecast cash flow for IVQ of 2016 and next 4 years (2017-2021). So my question is, should I discount by WACC only FCFF for IVQ 2016 and 2017-2021? or should I discount by WACC the FCFF for hole 2016 year and next 4 years (2017-2021)?

In my opinion I should discount only future cash flow, not this which ale generated by the company in the past. Is my view correct?

The whole exercise of discounting is only for future cash flows.

Ok, so combining my assumption with your (krokodilizm) assumption and with my example when I need value the company with date of 1 october 2016, I need to discount FCFF for IVQ 2016 and FCFF for 2017-2021 yes? So I will discount the IVQ 2016’s FCFF by (1+WACC)^(1/4) and next years by (1+WACC)^(1/(n+1/4))? Is my view correct/

n - year

Yes sounds fine and sophisticated enough.

Thanks, for quick answer :slight_smile: So maybe could you answers on my second question? :slight_smile:

I’m thinking, how to calculate WACC in case of changes in capital structure (D/E). When I’m preparing forecast of P&L and Balance Sheet I want to assume that the capital structure will change in next periods. As we know from MM assupmtion the the cost of equity for the company will increase when the company will issue new debt (will be more leveraged). So my idea to do this is that:

  1. Calculate the cost of equity for private company using unleveraged beta for similar public companies. And this will be my cost of equity (Ku) in situation when the company has not any debt.
  2. Next step, is to use the equation to: Ke = Ku + ((D/E)*(1-T)*(Ku-Kd)); where Ke - cost of equity when the company has debt; Kd - cost of debt; D/E - capital structure; T - tax rate. And in my excel sheet I will connect calculation of Ke with changing capital structure in next periods. Also I will add premium for small companies.
  3. Using this approach I will have different WACC in each period because of changing in cost of equity and changing in capital structure

What do you think about this assumption? Can I use this in practice? Do you have some experience in these area or maybe you have some different approach which I will can use?

You will still have to predict D/E each year. Why do you assume D/E will change each year?

A simpler and better approach is to use a target D/E, which can be provided by company management, for instance. Or maybe you can deduce this from the peers by taking an industry average D/E.

At the end of the day if you sophisticate the model based on assumptions you haven’t really added value to your model. What did they say about assumptions?

I think about target capital structure, but this company doesn’t achieve this level yet (as well as industry average D/E). So in my model this company achieve capital structure in second year. So I don’t know whether in calculation of WACC can I use target D/E even if the company doesn’t have this structure yet (and in first year of forecast)?

Also despite above problem, suppose that the company management say that they want to reduce debt in next three years? - and this will be new target D/E. We know that the debt will decline in each year by some amount (the D/E will be changing), so in my opinion WACC also should change in each year, till the company achieves target D/E. Am I right?

Just to add something; while that is accurate, people sometimes say “year is almost over, and we don’t want to update the valuation every day, so our assumption is this year’s cash flows are locked in, start discounting with next full year”. It pumps up NPV a bit, and nobody will challenge it as statistical manipulation, if it is footnoted. Then you just use current partial year cell + NPV function for future years.

Almost nobody does changing discount rate over time, but it does occasionally happen (I got a model from some IB this year doing this technique). A lot of times it is a question of accuracy vs understandability. If the model becomes too difficult to understand, or if people think you are “playing with numbers” and get suspicious, then the exercise loses persuasive power. You seem pretty smart, but most people in finance are not, sometimes you gotta dumb it down for them!

purealpha thank you for your response and advise. I’ve just started in area of valuation of private companies and maybe I focus to much on details. And you have right, that for people who are not deep in valuation techniques this could be misleading. Also, this is what krokodilizm said, that sometimes a huge amount of assumptions wouldn’t add value to models.

Also, I think that I will try to gain more knowledge in area of changes in capital structure and WACC and maybe in different model I would try to implement this.

^ Yeah, you’ll find it really depends on your audience/employer. I’m VERY detailed, in that I want to model reality as closely as possible (partial yr discounting, changing discount rate to reflect changing risk, etc), no lazy shortcuts! Some people like that and hire me specifically for that, others do not like that so I dumb it down for those audiences. Basically the customer is always right.

purealpha you mentioned that you changes discount rate to reflect changing risk, so I want to ask you which method do you use? Do you use method which I mentioned in my post above (MM assumption Ke = Ku + ((D/E)*(1-T)*(Ku-Kd)) ) ? Could you recommend some method and/or books in which I will find some deeper knwoledge how to implement changes in WACC and capital structure?

Damodaran often uses changing discount rates over time. If you want some spreadsheet examples, check his website. I’d recommend any of Damordaran’s books or his classes. He has executive and college classes online for anyone to view http://pages.stern.nyu.edu/~adamodar/