Public company multiples are ordinarily a good starting point when doing business valuations of private companies in advance of negotiating a merger or acquisition. While conducting business valuations, the problem with using public company multiples in a slumping economy is unless the seller is in a distressed sale situation, the bid/ask spreads are often too wide and investors miss out on good deals. One of the most commonly used tools in business valuations is the discounted cash flow (“DCF”) model. DCF models project a business’s cash flows over a number of years and discount the future value of those cash flows to present values based on a discount rate, generally reflective of the investor’s desired internal rate of return (“IRR”). Often public company multiples are used in tandem with the DCF model, and many investors will use the lower of the two business valuations to guide their bids.
The problem with relying on public company multiples to do business valuations of private companies in a slumping economy is two-fold. First, an investor will rarely if ever, take a controlling interest in a publicly traded company at a price anywhere near the stock’s 52-week low. In fact, the price to which the selling shareholders will agree will likely be closer to the 52-week high. How many times have public companies’ stock prices spiked 25% or more on the announcement of a merger or acquisition? Finally, using public company multiples in private business valuations suggests the business has limited future earnings potential based on present economic conditions. The discounted cash flow model is the best business valuations tool because it clearly identifies the price an investor should pay for the business based on that investors IRR guidelines, not on the depressed market price of a public company’s common stock.