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is a common method used to estimate the fair market value of private companies. The premise of the methodology is to estimate the company’s value by comparing it to similar publicly traded companies. One common method compares a company’s after-tax profits and multiplies it by the average price to earnings (P/E) ratio of its public competitors. Other methods compare company sales and multiply by an average price to sales ratio. For example, a private widget company with after-tax earnings of $1.5 Million might estimate its fair market value at $15 Million if its public company competitors had P/E ratios of ten. Sometimes discounts are applied to the model to account for the differences in value between companies with publicly traded securities and the restricted securities held by private company shareholders. If a 20% "liquidity" discount were applied in the preceding example the company value estimate would be reduced from $15 Million to $12 Million. Like all valuation methods, the market price method is imperfect and should be used with other models, such as the discounted cash flow model, when estimating company value. A description of how the market price method is used to estimate values of rapidly growing companies using a company’s projected financial statements is contained in the Pricing entry. Another common method for valuing growing companies, the Discounted Cash Flow method, is also described in this book. See: Discounted Cash Flow, Negotiation, P/E, Price Earnings Ratio, Pricing. |
