Valuations Based on Public Company Data

I am currently completing a valuation that has taught me much about whether to value a private company using public guideline methods.  The subject is large enough to use these methods, but little else supports them.  This post explains my thinking.

Some background assumptions:

1. A control interest will be sold to a trust benefiting the owner’s heirs.
2. All other shares will be privately owned.
3. The fair market value standard applies: this is a tax-related transaction.
4. The Company is a going concern but performance is down due to the recession.
5. The valuation date is current.
6. The subject’s basic business and financial positions will not change
7. Performance will improve with the economy, but the business is highly cyclical.

The attorneys handling the transaction are very sophisticated. They have handled many public offerings as well as compliance matters for public companies.  They also wanted their client to realize the highest possible price from the transaction, and were been very open about that.  They hoped I would value the subject considering public pricing methods, which would yield a higher value than those I deemed appropriate.

I could not in good conscience do so, and we engaged in a constructive debate about my reasons:

1. I could not find any similar and relevant guideline companies or transactions.  Although some were of similar size and market share, they were far more diversified in products, markets, and distribution channels than the subject.  They had much deeper managements; the subject is highly dependent on the current owner’s expertise, and there is no successor in place.  Their performance was much more stable than that of the subject, whose manager has taken big (and successful) risks speculating on raw materials prices, building up and shedding inventories.
2. There have been no acquisition transactions in the industry this year (due to the recession), and the economic decline invalidates the comparability of older deals, many of which were also strategic (which are not part of fair market value).  Moreover, many of the possible guideline companies are themselves thinly traded, which calls into question the applicability of those prices to value a control interest.
3. It is not clear to me that the Initial Public Offering (IPO) market window is open for a company like this at the present time.  The company has not talked to any investment bankers or otherwise prepared for an IPO.  It does have audited financial statements (which are clean), but it does not prepare forecasts, and (this was very significant to me) has not considered the costs of going public (in terms of the initial offering itself as well as ongoing compliance costs, which would materially reduce earnings and cash flow).  Had the Company shown me an IPO proposal from a reputable investment bank (an oxymoron these days?) that promised to underwrite the securities (i.e. buy and resell them) as opposed to a best-efforts offering (where they purchase only what they can sell, and do not hold onto unsold shares), I would have been more amenable.
4. The prices indicated by public guidelines could not pass a justification of purchase test (based on rough cash flow projections I prepared), by a considerable margin.  This cast doubt upon whether there would be willing buyers.
5. The Company does not need additional capital.  The IPO would be primarily a secondary offering, in which current owners sell shares to the public, and the Company receives no proceeds (but bears the transaction and compliance costs).  These can be problematic: buyers will ask why the owners are “bailing out”.
6. I was simply not satisfied that the control owner would even want to go public, which would entail quarterly earnings pressures, much more disclosure, and institutional scrutiny.  The owner is an extremely private person; this just made no sense to me at all.

The only counter-arguments I received were:

1. The Company could be sold to a public company.  True, but strategic purchases are ruled out by the fair market value standard, and financial buyers need to see the justification of purchase test (cash on cash return on investment).  This argument might favor some sort of leveraged recapitalization, but the business itself is not conducive to that because of its cyclical revenues and earnings.  Moreover, as above, there have been no meetings with investment bankers or intermediaries to support this.
2. You use public market data to build up your Income Approach value, so why not use Market Approach data?  True, but I also add a specific company equity risk premium (which was substantial and undisputed for the subject).  If I use public guidelines, the issue of the “comparability adjustment” (private companies have lower multiples than public ones) arises, which removes much of or the entire public company value premium.

In the end, they accepted my reasoning and report and paid me.  But they also commissioned another (highly qualified and honest) appraiser who is more wedded to public company methods than me, received a higher valuation from him, and used a blend of our two conclusions to price the transaction.