Private equity (PE) firms continue to attract investors looking to maximize returns and minimize risks. In fact, private equity fundraising has seen a substantial rise. According to Bain & Company, global funds raised across the full private capital spectrum hit $1.2 trillion in 2021 – a 14% increase from the prior year.
Market trends show plenty of dry powder in the sector, but before investing in a company, PE firms must value it. Private equity valuation best practices provide guidance and critical insights on how firms weigh various factors to value a company and assess its potential growth.
Let’s begin by discussing private equity valuation methods.
How Private Equity Values a Company
Investors can use private equity valuations to help determine the proper pricing of potential investments. The valuations involve complex calculations that include analyzing a company’s current metrics and future potential to make a sound investment decision.
There are various methods for valuing a private company, such as:
PE firms assess the competitive landscape of the company’s industry. They conduct market research to better understand the company’s position and identify potential risks and opportunities.
This method for how private equity values a company involves researching publicly-traded companies that most closely resemble the target company. The best comparable is one that’s of similar size, age, and growth rate.
Discounted Cash Flow (DCF)
The DCF method attempts to value an investment today based on projections of future cash flows.
Precedent transactions analysis compares an acquisition opportunity to other companies that have recently been sold or acquired in the same industry.
Leveraged Buyout (LBO)
An LBO transaction is an acquisition funded using a significant amount of debt where assets from both parties are used as collateral.
Private Equity Valuation Best Practices
To ensure the accuracy and reliability of private equity valuations, firms should adhere to certain private equity valuation best practices:
Judge the best valuation methods
There are several valuation methods, such as those mentioned above. PE firms need to determine the most suitable method based on the target company’s characteristics, industry, and available data and weight those more heavily.
Use multiple valuation techniques
To increase the reliability of the valuation, it’s essential to employ multiple techniques and cross-check the results. This approach can provide a range of values, helping to identify potential risks and opportunities.
Conduct thorough due diligence
Comprehensive due diligence is critical to obtaining accurate and reliable information about the target company. This includes analyzing financial statements, legal documents, management team credentials, and industry trends. Rigorous due diligence helps to identify potential risks and opportunities, which can impact the valuation.
Apply industry-specific knowledge
Understanding the target company’s industry, competitive landscape and key value drivers is vital for a credible valuation. Applying industry-specific knowledge can help to identify sector-specific risks and growth prospects, which should be factored into the valuation.
Update the valuation regularly
Private equity valuations should be updated periodically to account for new information, changes in market conditions, or company performance. Regular revaluations allow PE firms to make informed decisions about their investments and adjust their strategies as needed.
Document assumptions and methodologies
PE firms should maintain a clear and detailed record of the assumptions, methodologies, and data sources used in their valuations. This documentation provides transparency, facilitates internal and external reviews, and ensures consistency across multiple valuations.
Seek external expertise when needed
In complex transactions or industries, it may be beneficial to seek the advice of external valuation experts or industry specialists. Their expertise can help validate assumptions, methodologies, and conclusions, increasing the overall credibility of the valuation.
Employ advanced technology
Leveraging artificial intelligence (AI) and machine learning (ML) technologies can enhance the private equity valuation process. These technologies can analyze vast amounts of data and identify patterns, trends, and relationships that might be difficult for humans to discern. Some key applications of AI and ML in private equity valuation include:
- Automated data analysis: AI and ML algorithms can rapidly analyze large volumes of financial and non-financial data, providing insights that can be used to refine valuation models and assumptions.
- Predictive analytics: Machine learning models can be trained to predict future financial performance and identify potential risks and opportunities, helping to inform valuation assumptions and methodologies.
- Sentiment analysis: AI can provide insights into market sentiment and trends by processing and analyzing news, social media, and other data sources. This information can be valuable for identifying factors that may impact the target company’s value.
- Benchmarking and comparables: AI and ML can help in selecting more appropriate comparables by analyzing a larger set of peers and precedent transactions, ensuring consistency and comparability in valuation approaches.
- Reducing human biases: By automating certain aspects of the valuation process, AI and ML can help to reduce the impact of human biases, leading to more objective and reliable valuations.
By adhering to these private equity best practices, firms can produce accurate and reliable valuations, enabling better-informed investment decisions and enhancing their ability to generate returns.
Supercharge Your Private Equity Valuation Methods With udu
With udu, your PE firm can take advantage of AI-driven private equity valuation solutions to increase accuracy and decision-making speed. udu is also equipped with machine learning capabilities, allowing it to learn which deals you want to focus on and which to ignore.
Easily compile detailed valuations of private companies in a fraction of the time it would take to do the same job manually. By automating mundane tasks such as calculating multiples and analyzing financial statements, udu helps firms increase efficiency while avoiding costly mistakes. Want to learn more about how udu, a leading private equity deal sourcing platform, can improve the accuracy of your private equity valuations? Request a demo.