How Do Private Markets Work?

When investing in the public markets, we often take several things for granted. One of the most elemental is the valuation of the company or startup in question.

After all, how can you buy something if you don’t know its price tag?

Without the share price, investors are forced to become more creative. They use several other methods to calculate market value. In this chapter, we’re going to take a deep dive into how private market funds calculate the valuation of startups. We will understand three of the most popular valuation methods in detail.

Comparable Company Analysis (CCA) is based on the premise that if we don’t have all the information about a startup, we can draw parallels with others in a similar situation. Fund managers look at the financial metrics and valuation multiples of other companies that are similar in terms of size, industry, and other relevant characteristics.

This, of course, means that fund managers have to find other similar startups in the same industry. If it’s a new industry or there isn’t a direct competitor, then this method might not fit.

Here’s how it works:

1. Selecting Peer GroupThe first step is to identify a group of peer companies. These are businesses that are comparable to the company being analysed in terms of industry, size, geographic location, and other relevant factors.For example, if you’re analysing a tech company, you’d choose other tech companies as peers.
2. Collecting DataThe fund managers then collect detailed financial data for both the target startup and its peers. They look at data such as revenue, earnings, debt, and valuation ratios like P/E, P/S, and EV/EBITDA.
3. Calculating Valuation MultiplesFund managers then calculate these valuation multiples for both the target startup and its peers. For instance, if you’re looking at the P/E ratio, you’d divide the stock’s price per share by its earnings per share (EPS).
4. ComparisonThe next step is to compare the multiples for the startup with the multiples from its peer group. If the target startup’s multiples are higher or lower, it indicates whether it’s overvalued or undervalued relative to its peers.
5. Estimating ValueThe comparison gives a relative picture of what the value of the startup can be. For instance, if the peers have an average P/E ratio of 15, and the target startup has a P/E ratio of 20, it means its value is higher than its peers.

Key Takeaways

• CCA is used to assess a company’s value relative to similar companies in the same industry.
• Common valuation multiples used in CCA include P/E, P/S, P/B, and EV/EBITDA.
• CCA helps investors and analysts make informed decisions about whether a company’s stock is overvalued or undervalued.
• The accuracy of CCA depends on the quality of the selected peer group and the relevance of the chosen multiples.

Let’s understand this better with a numerical example. Suppose we have two companies in the same industry, Company A and Company B, and we want to compare their valuations using the Price-to-Earnings (P/E) ratio.

For Company A,
Price per Share: ₹100
Earnings Per Share (EPS): ₹10

For Company B, we know that the earnings per share is ₹20. But we don’t know what its share price should be. All we know is that the two companies are peers and have comparable P/E ratios.

Now, let’s calculate the P/E ratio for Company A:

P/E Ratio = Price per Share / Earnings Per Share
P/E Ratio for Company A = ₹100 / ₹10 = 10
If we assume that Company B will have a similar P/E ratio value, we can find the estimated price per share.

10 = Price per share / ₹20
Price per share = ₹200

PTA is similar to CCA. But instead of valuation metrics, it focuses on analysing companies that have been involved in similar mergers or acquisitions.

In other words, fund managers look at the funding rounds of similar startups. They consider the precedent set and use it to estimate the potential value of the target startup.

Step 1: Identify Relevant Transactions

Start by looking for past deals (mergers, acquisitions or funding rounds) in the same industry and of similar size as the target company.

Let’s consider, for example, the valuation of a startup in the ed-tech space. The deal in question is from an early fund-raising round.

Step 2: Gather Data and Set Criteria

Collect data on these transactions, like the purchase prices and financial metrics. Set criteria to filter relevant deals, like industry, financials, geography, and deal size.

Continuing with the previous example, fund managers will identify similar situations — early fundraising rounds for ed-tech startups — to gain an understanding.

Industry: Ed-Tech
Deal Size: $50 million to $100 million
Geographic Location: India

Step 3: Calculate Valuation Metrics

Calculate valuation metrics like Enterprise Value-to-EBITDA (EV/EBITDA) for each of the past transactions.

Let’s assume that for one of the past deals, EV/EBITDA is 7x.

Step 4: Determine a Valuation Range

Find the average or range of these valuation metrics to create a benchmark for valuing the target startup.

Example: The average EV/EBITDA multiple from the five deals is 6x, with a range of 5x to 7x.

Step 5: Apply the Valuation Metrics

Apply the valuation metrics to the financials of the target company to estimate its value.
If the startup’s EBITDA is $50 million, its estimated value range would be:

Low end: $50 million * 5 = $250 million
High end: $50 million * 7 = $350 million

So, based on precedent transactions, the startup’s estimated value is between $250 million and $350 million.

As the name suggests, the DCF method is based on the premise that a company’s worth is determined by its future earning potential. This means that if we calculate the present value of all the future earnings of the company, then we simply add it up to get the total value!
Let’s go through it in detail.

Step 1: Forecast Future Cash Flows

Estimate the cash the company will generate in the future. For this step, fund managers delve into the details of any potential revenue source. The objective is to be as accurate as possible. This often involves predicting revenues, costs, taxes, and more.

Step 2: Determine a Discount Rate

The future cash flows, although accurate, are just that. “Future”.
But to calculate its present value, fund managers have to use an appropriate discount rate that takes into account the effect of inflation.

Step 3: Calculate Present Value

Each future cash flow is then converted to its present value using the discount rate.

Step 4: Sum up the Present Values

The sum of these present values gives the estimated valuation of the startup.

Example:

Let’s consider a startup that projects the following cash flows for the next three years.

• Year 1: ₹1 crore
• Year 2: ₹1.2 crore
• Year 3: ₹1.5 crore

For the sake of simplicity, let’s assume a discount rate of 10%. This means the present values of these cash flows are:

• Year 1: ₹1 million / (1 + 0.10)^1 = ₹9,09,090.91
• Year 2: ₹1.2 million / (1 + 0.10)^2 = ₹9,90,909.09
• Year 3: ₹1.5 million / (1 + 0.10)^3 = ₹11,24,579.12

₹9,09,090.91 + ₹9,90,909.09 + ₹11,24,579.12 = ₹30,24,579.12

So, based on the DCF method, the present value of the startup is approximately ₹30.24 crores.

In India, the alternative investment space is regulated by the Securities and Exchange Board of India (SEBI). Earlier, the regulations included the minimum investment amount, the disclosure norms, and other factors. However, as per an amendment introduced on June 21, 2023, AIFs will have to use a standardised approach while valuing their investment portfolios.

Let’s take a look at the main changes introduced:

1. Any securities whose valuation norms already exist under the SEBI (Mutual Fund) Regulations 1996, need to be valued according to those norms.
2. Any securities that are traded need to be valued at the last quoted price on the stock exchange.
3. Any other securities that are not mentioned in the mutual fund regulations will be valued based on the guidelines set by the AIF Industry Association.

“Pre-money” and “post-money” refer to the valuation of a company before and after an investment.

Pre-money valuation is the value of a startup immediately before it raises funding. It does not include the funds that are being injected into the company during the current financing round.

For example, if a startup is said to have a pre-money valuation of ₹10 crores, it means the company is valued at ₹10 crores before the new funds are added.

Post-money valuation, on the other hand, includes both the pre-money valuation and the new capital from the current round of financing.

If the startup raises ₹2 crores in a new round of funding, its post-money valuation becomes ₹12 crores (₹10 crores + ₹2 crores).
As for the fund’s ownership stake,

Ownership % = Investment Amount / Post-Money Valuation
This means the fund that invests ₹2 crores gets an ownership stake of 16.67%.