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Private Company Valuation

Two of my grad skool classes (econ & finance) taught this topic as part of its curriculum and both professors had us neophytes look at quantitative data with respect to publicly traded companies; but what if you are trying to do a valuation of a privately held company. Can you train your intuition to be as good as the eons of financial valuations done by the professionals?

What do we know about a company? Does it matter who founded it or who their VC backers are? Does it matter more if end users actually like the products and services offered? And, how would you even know if it's the right time to buy? What can LinkedIn do that similar competitors cannot? What is their competitive advantage?

First things first. I haven't invested in the stock I'm about to talk about in this post. I thought about it quite a bit, but a SaaS vendor that is relatively new on the block and as one that embraces emerging technologies, it falls outside my personal criteria for investing in new stocks. I have been a basic end user since they launched; and I heard about it from a colleague. Word of mouth marketing is pretty powerful stuff. These days, it's nearly mandatory for business students at the undergrad or graduate level to have a LinkedIn profile. I have a user profile where I allow some public (non-login) access to; though you can see much more if you are also a member of the site. And, for the most part, for those of you without a dedicated site for your resume or portfolio, this is a good business networking site to connect with or show others in the industry or prospective markets what you are all about.

The site serves three distinct markets: human resource professionals, business end-users, and advertisers that want to market products/services to site users. For business networking sites, LinkedIn has few competitors using the freemium model, such as Germany's Xing (65 million members) or France's Viadeo (30 million members). Bloomberg, D&B, or Hoovers often provide basic data and company overviews. If we looked purely at the site being for mid- and executive level job seeker members, the site also competes for pocketshare with Execunet and TheLadders.

Over the last couple years, LinkedIn had been quietly rolling out web technology advancements and key partnerships with app add-ons, relevant ones that help sell a user's online business persona. Google AdSense ads have also recently appeared on the site too; though, they appear to be there to help the site pay for itself rather than be direct attempts at forming partnerships with key advertisers (though, the site has that feature too).

The target offering price of $45 is fair. It's the starved market that has pushed the price above $100/share. Is it sustainable at that price? Probably not, but investors don't care. If you're looking for a rational explanation for the jump in price, you won't find one on talk radio or the financial news hour on television. Investing isn't about rational decisions, it's based on GRIEF (according to one of my professors): Greed (Return, Income, Earnings) Fear. Anyhow, back to the topic at hand.

Companies typically go public to raise their status (more media coverage, more marketing), attract new customers, fund business expansions or R&D initiatives, and/or pay off existing debt and early-stage investors. Private company valuations are done to help sell the company, raise additional capital from investors, for a management buyout, for estate planning, for creating an ESOP plan (employee stock ownership plan), or for tax purposes.

To valuate a private company, one method is to look at the pre-IPO or SEC filings of existing competitors that are publicly traded or who are open about their earnings and revenues. The statements that privately-held companies make in these filings shed the best possible light into who they are and what they stand for; and are pretty good browsing for those who want to launch a similar concept or business.

A second method is to look at quantitative figures such as beta (how much market risk when compared to others in the industry), cash flow, or market capitalization (share price x outstanding shares). Here is a decent overview of how to calculate beta and total risk; this PDF link comes from Aswath Damodaran's NYU page.

A third method is to use Inc Magazine's valuation calculator or site resources. Industry data is already neatly aggregated for users to see sector averages for different types of businesses; and from the options of the drop-down box for industry, it is based on standard industry classification (SIC) categories, or its more modern counterpart NAICS. The interactive visual calculator looks at multiple quantitative data points such as industry median sales and revenues, net sales, gross profit, EBIT (earnings before income and taxes), EBITDA (earnings before interest, taxes, depreciation and amortization), discretionary earnings (operating profit, owner compensation, and noncash charges), and BVIC (book value of invested capital).

There are a lot more strategies out there beyond the top three listed here. To make an informed decision about whether or not to buy the stock of a privately-held company, you'll have to engage in more than one method of valuation.
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