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This study is a comprehensive field study presenting evidence on how financially sophisticated corporate financial advisers and private equity fonds apply present value approaches in valuing privately held firms. Previous studies on valuation have been concerned primarily with listed companies, and to our knowledge no prior studies have empirically explored how practitioners address problems related to the use of present value approaches on privately held firms. Our field study is valuable for a number of reasons. First, valuation theorists have long recommended present value approaches such as the discounted cash flow (DCF) model and the economic value added (EVA) model for firm valuation (Penman [1997]). Popular textbooks such as Stewart [1991], Rappaport [1998], Copeland et al. [2000], Pratt et al. [2000] and Damodaran [2002] have increased practitioners' awareness and understanding of present value approaches. Still, most of the valuation literature ignores valuation of privately held firms. For example, neither Rappaport nor Copeland et al. address valuation of privately held businesses.1,2 While valuation of listed companies is complicated, valuation of a privately held firm introduces a range of additional issues. For example, stock market data are not available, which make estimation of the cost of capital difficult. Further, the annual report is less informative, making projections of future cash flows more uncertain. Lack of marketability raises the additional issue of how to estimate a marketability discount.
Second, valuation of privately held firms has become increasingly important in recent years. The number of mergers and acquisitions (M&A) involving privately held firms has increased considerably. Ang and Kohers [2001] find that the volume of acquisitions involving privately held firms has soared to record heights. Based on U.S. data, they find that over the period 1984-1996 more than 22,000 acquisitions involving privately held firms have occurred, while 8,000 mergers and acquisitions have involved publicly traded firms. According to Initiative Europe [2005], privately owned businesses accounted for most of the M&A activities in Europe over the period 2000-2004. This development is further stimulated by generational change. In Denmark, approximately 2,000 privately held firms are estimated to change hands within the next few years due to generational change (Vaekstfonden [2004]). This tendency is echoed in other parts of Western Europe, the U.S. and Asian-Pacific region (e.g., Australia) as well.
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