Valuation Approaches, Exit Strategies, and Liquidity (CFA Level 1): Valuation Approaches for Private Companies, Discounted Cash Flow (DCF) Analysis, and Comparable Company Analysis. Key definitions, formulas, and exam tips.
Perhaps you’ve heard a friend excitedly talking about investing in a startup or participating in a private equity deal—these stories are filled with big dreams of growth, but they can get pretty complicated once you peel back the layers. Well, private capital investments, whether in equity or debt, often hinge on detailed and careful valuations. And these valuations don’t just pop out of thin air; they’re influenced by market conditions, industry trends, macro cycles, and even the personalities sitting around the negotiation table.
In this section, we’ll cover major valuation methods used for private companies, explain why it’s so important to factor in illiquidity when working through valuations, and detail common exit strategies to help you envision how investors eventually realize returns. We’ll also discuss how to manage liquidity constraints over the life of a private investment. So, buckle up. Let’s dive in.
One thing that caught me off guard early in my career was just how differently private and public companies can be valued. Unlike public equities—where share prices are flashed at you in real time—private firms don’t have that readily available “market price.” Instead, we rely on multiple valuation techniques, each giving us a slightly different perspective.
The DCF method is rooted in projecting a company’s future cash flows and discounting them to the present value using an appropriate discount rate (often denoted r). This model is a cornerstone of corporate finance and a favorite among many analysts looking at private equity investments.
Here’s a simplified representation of the equity value derived from a DCF approach:
$$ \text{Equity Value} = \sum_{t=1}^{n} \frac{FCFE_t}{(1 + r)^t} $$
Where:
If you’ve ever cracked open a thick financial model, you know these forecasts can be sensitive to even tiny changes in assumptions. A 0.5% tweak in the discount rate could change your final valuation by millions (or billions) depending on the scale. It’s crucial to test different scenarios—like “best,” “base,” and “worst”—to see how the investment’s value holds up under varied conditions.
Sometimes known as “comps,” this approach involves comparing the target private company with a set of publicly traded peers. We look at valuation multiples (like EV/EBITDA, P/E) and see where the private company might stack up.
But watch out for a mismatch: the private firm might be smaller, less diversified, or have a narrower distribution network. Adjusting for these differences is as much an art as it is a science. Comps can be enlightening, but you always need to qualify the analysis with a good understanding of how the companies differ.
In many private equity deals, you’ll see bankers pitching a “precedent transaction” approach—basically, analyzing multiples paid in similar M&A or leveraged buyout (LBO) transactions. This method looks at historical deals in the same sector or with a similar growth profile. Sometimes, especially in hot markets, multiples can skyrocket and you might see valuations that defy logic (because maybe the buyer had strategic reasons to pay a premium).
Again, do your homework: confirm the time period of the transactions, the reason behind any premium (like synergy potential or a strategic rivalry), and the capital structure used to finance the deals. A robust set of transaction comps can be super helpful, but outdated data from five years ago might not reflect current macro conditions—especially if interest rates or sector fundamentals have shifted drastically.
Every so often, particularly in asset-intensive industries (real estate, heavy manufacturing), we rely on adjusted book value. This entails taking the company’s balance sheet assets and liabilities and reevaluating them to better reflect fair market values rather than historical cost. While it’s often a more conservative approach, it’s useful if the target is close to or at liquidation value, or if you want a baseline to see how intangible assets (like intellectual property) or intangible liabilities (like certain off-balance-sheet items) might affect the overall valuation.
Unlike shares of a publicly traded giant, a private investment can’t just be sold tomorrow at the click of a button. This liquidity gap typically commands an “illiquidity discount.” Investors often apply a certain percentage discount to valuations to compensate for the slower (and more complicated) process of exiting the position.
The magnitude of this discount can vary widely—some might apply a 10–20% discount, while others might go higher depending on factors like the type of industry, the stage of the company (e.g., high-growth startup vs. mature, cash-generative business), and general economic conditions. In a booming economy with plenty of strategic buyers lurking, the illiquidity discount might shrink. In a slow, risk-averse environment, you might see it widen as it becomes tougher to find motivated buyers.
You might be thinking, “So I’ve bought these private shares… how do I ever see my money again?” Exit strategies are the bread and butter of private capital investing. Here are four of the most common ways out:
One time, I watched a small regional chain of specialty coffee shops pivot to a national brand under private equity ownership. Eventually, they pursued a secondary buyout, handing the company over to a larger private equity group with more growth resources. The original PE fund locked in a healthy return—no IPO needed, no trade sale. Just a new financial partner with a fresh plan.
Private equity investments typically have holding periods of anywhere from three to seven years—though some can stretch far longer if the road to growth is bumpy. During that time, the sponsor and investors might have limited (or no) ability to cash out. That’s why many limited partnership agreements (LPAs) impose lock-up periods or severely restrict transfer rights.
It’s wise to identify potential buyers (strategic or financial) early on. Let’s say you’re investing in a niche manufacturing company. You might keep a short list of potential industrial giants that could see synergy in buying you out. Or you might keep an eye on vertical integration trends that could spark interest from a bigger fish in the supply chain.
Short version: plan for the illiquidity. You can’t necessarily “hammer out” if the market dips. If your main capital has a large chunk tied in private deals, you likely need to keep enough in liquid assets that you don’t get stuck in a cash crunch.
Valuations of private companies rarely exist in a vacuum. Economic indicators—like interest rates, inflation, and GDP growth—can influence the discount rate you use in a DCF, affect how generous or stingy buyers might be, and even shift entire industries. For instance, a steep rise in interest rates can dampen buyout activity because the cost of leveraged debt skyrockets.
Likewise, consider the cyclical or secular trends in the company’s industry. Are we dealing with a hot “disruptive tech” sector with sky-high innovation potential? Or is it a stable, mature industry with relatively limited growth prospects? Both can present opportunities, but the multiple you’re likely to pay—whether 5× EBITDA or 15×—can vary drastically. Keep an eye on broader market sentiment, as it can fuel or suppress exit opportunities.
When multiple investors—say, different private equity funds or co-investment partners—share the same cap table, you might encounter misaligned incentives. One investor might want to exit at year four, while another is eager to keep the company growing until year seven. This can spark tension and slow down negotiations with potential buyers.
Clear documentation on “drag-along” or “tag-along” rights can save you a headache. These provisions define what happens if a majority investor wants to sell and how minority shareholders can respond. It’s best to clarify from the start: if the ideal exit comes early, do we all agree to move forward?
Back when I was new to building financial models, I learned quickly that “stuff happens” in real-world business. So stress testing is essential. By adjusting key assumptions—like revenue growth, operating margins, or the discount rate—you see how fragile (or robust) your valuation is.
This helps ensure your capital structure is prepared for unexpected turbulence. Stress testing is also beneficial for negotiating with other stakeholders who might question your assumptions.
A moment of real talk: nobody likes rummaging through disorganized financial statements or incomplete corporate records during due diligence. Thorough documentation from day one pays off big when the exit moment arrives. Keep an up-to-date data room with:
When a potential buyer sees you’ve got everything in order, it can significantly speed up negotiations (and might even support a higher valuation).
Let’s imagine you’re valuing a small enterprise software startup poised for significant growth—think big data analytics for Fortune 500 companies. You might:
This approach gives you a robust sense of the potential valuation range. Then it’s about negotiating the final deal terms with the founders and existing investors.
Below is a simple Mermaid diagram illustrating a typical private investment lifecycle, from initial due diligence to exit:
flowchart LR
A["Investment <br/>Opportunity"] --> B["Due Diligence"]
B["Due Diligence"] --> C["Valuation & Terms"]
C["Valuation & Terms"] --> D["Capital Injection"]
D["Capital Injection"] --> E["Value Creation"]
E["Value Creation"] --> F["Exit Strategy"]
This high-level flow also underscores the importance of planning for valuation, exit, and liquidity from day one.
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