Nowadays, an increasing number of companies are opting to stay private for longer, bypassing regulations and public stakeholders. While the total number of US companies continues to grow, the number of those traded on stock exchanges has fallen 45% since peaking 20 years ago.
As reported by The Economist in 2017, the number of publicly listed companies was 3,671, down from 7,322 in 1996. Thus, private company valuation has risen to the forefront, especially since it is required for anything from potential acquisitions to corporate restructuring and financial reporting. Understanding how discount rates are estimated and their role in financial decisions is important to both private business owners/operators and investors/valuation professionals. Unlike public company valuation, private company valuation often lacks publicly available data. However, both types of valuation have something in common: usage of the discounted cash flow (DCF) analysis, which requires (1) estimation of future cash flows and (2) a discount rate.
This article focuses on best practices for estimating private company discount rates, or the weighted average cost of capital (WACC), drawing on my 12 years of experience performing private company valuations and various editions of Cost of Capital: Applications and Examples. The discussion begins with an overview of the DCF analysis and the WACC, followed by detailed instruction around the components of the WACC. While this article will cover WACC as taught in accounting classes and the CFA program, it will also demonstrate how best to handle challenges encountered in practice. Perhaps unsurprisingly, a lot of classroom rules break down in the real world. And, since variables for estimating WACC are not simply pulled from a database, much analysis and judgment is required.
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