Valuation Perspectives for the Private Markets
Chapter 1 outlined the differences in the private capital markets and traditional corporate finance theory with a focus on laying the foundation for understanding middle market M&A, particularly for privately or closely held businesses. This chapter continues that theme by providing a high-level overview of valuation and how to frame the valuation analysis in the context of doing deals; it describes the fundamental concepts underlying private business valuation. Keep in mind that valuing a business is a blend of art and science, with a reasonable level of subjectivity.
Business valuation is an attempt to estimate the balance between risk and return in an entity. What exactly is risk? Most analysts view risk as the degree of uncertainty in terms of the amount and timing of realizing expected returns.
Thought of in this way, we can view risk as the capital market's assessment of the likelihood that a subject will actually achieve its expected returns. Business appraisal quantifies this risk assessment as a company's cost of capital.
An underlying principle of all valuation is that risk and return are related. With a greater perceived risk of owning an investment, a greater return is expected by investors to compensate for that risk. The desire to achieve a return that is at least equal to the corresponding risk is the primary motive for investors to bear the uncertainty of investing.
Investors expect to earn a certain return ...