Avoid Using Price-Earning (PE) Ratio to Valuated Private Companies.

There will be a point in time where you will start valuing your company and there are different approaches in doing so. There are 3 categories of valuation namely the income approach, market approach and asset/cost approach.

These approaches can be found everywhere but it is often being misused and hence misvaluing the company. Using the right valuation approach will not only ensure the price is satisfactory and also make you look more professional. It will increase your chance of getting the company sold at the earliest possible time.

There are many uncertainties in the market and what every seller wants is to let go of their company fast. We set those unmotivated sellers aside or the ones who are simply shopping for buyers with a good price. There are many reasons for the seller to sell their company, some harbour ill intentions such as their company is not doing well or is heavily indebted.

Regardless of their reasons to sell, it is crucial for the buyer or his representatives to do proper due diligence and ensure there is no repercussion from buying the company. Buying a company is not always for profit purposes, they could buy for strategic reasons or to simply eliminate their competition.

Anyway, we are not to discuss the reasons on why buyer and seller exist. We are here to avoid using the wrong valuation technique. This article I am going to discuss the price-earning ratio under the market? approach. Market approach is a comparison based on the multiple from sales of similar companies.

The only valuation approach that is definitive is the asset/cost approach as there is an immediate value of the asset. Both income and market approach are the projections or estimations on the future performance of the company. Income approach is based on its internal figures while market approach is based on the numbers of similar companies.

Price-Earning (PE) Ratio

It is calculated by taking the latest closing price and dividing it by the most recent earnings per share (EPS) number. The PE ratio is a simple way to assess whether a stock is over or undervalued and is the most widely used valuation measure.

The formula of PE ratio:

Market value is very straightforward and that is why we cannot use PE ratio for private companies. The market value of a company has to be determined publicly and that is why PE ratio is used to value listed companies only. By measuring if a stock is over or undervalued, investors sell or buy according to such information. Over a period, the market will usually correct itself and therefore any over or undervalued stock will return to its normalcy.

Back to market value per share, even if your account is being audited and verified, it is still a private share and anything could happen to it. Private shares have private ownership and can easily be implicated by the private shareholders. The level of depth to scrutinise is deep and there is no guarantee immediately after auditing the private shareholders did not perform any actions that could affect the company’s share price.

Unlike public companies, any actions or decisions have to follow certain policy and the amount of harm an individual can do is limited. Beside that, public shares can be easily sold in the open market through exchange or brokerage. Due to such a mechanism, the PE ratio has an assurance in it and therefore only public companies can rightfully use it for valuation.

EPS on the other hand is to measure the bottomline of a company. It can be calculated by using the difference of net income and preferred dividends over average outstanding of common shares.?

It is a little grey when it comes to EPS as the price of the common shares can be determined by their own issued shares for the accounting period for non-public companies. This value for private companies can be altered or misreported for their own convenience as they can do all the nominee or proxy share allocation. Unlike a public company where their shares are not supposed to be used to one’s advantage and is being controlled cum monitored by many parties

All in all the PE ratio should not and cannot be used for private companies. It can be used as a comparison for similar companies but there are many bias points. If it is being used comparatively, a 50% buffer should be set in place for the valuation.

To calculate PE ratio:

Company A public share price: $5.60

Company A fiscal year net income: $54 billion

Company A preferred stock dividend: $10.6 billion

Company A average outstanding common shares: $33 billion

EPS = ($54b - $10.6b) ÷ $33b = $1.315

PE ratio = $5.60 ÷ $1.315 = 4.26

The higher the PE ratio shows the more valuable a company is and the more investors are willing to pay for its shares. The proper way to compare PE ratio is with a market standard such as how other competitors in the public market are valued and what is the industry standard. Once again, it should not be used to compare between public-private or private-private companies.