There seems to be no bounds on the mega amounts that private equity firms are willing to pay. Just some of the deals include the $29 billion purchase of First Data (NYSE: FDS) and the $45 billion buyout of TXU (NYSE: TXU).So how do the pros come up with these valuations? Well, I had a chance to talk to Michael Wolfe, who is with Fesnak and Associates, LLP. He is not only a CPA but also has the ABV (Accredited in Business Valuation) and CVA (Certified Valuation Analyst) designations.
In his practice, Wolfe conducts valuations for a variety of private equity firms. "There are different approaches to valuing a buyout," he said. "But it really boils down to buying a stream of future cash flows."
To this end, Wolfe uses the discounted cash flow (DCF) method. This involves a projection of cash flows -- and even accounting for different scenarios.
There also needs to be a discount rate, which is an estimate of the risk of achieving the cash flows. "With the large influx of money into private equity firms," said Wolfe, "we are seeing discount rates fall in general. I'm not sure this means the actual risk has gone down. Only time will tell. So going forward, it will certainly be tougher for private equity firms to get the kinds of returns they have been getting over the years."
Tom Taulli is the author of various books, including the Complete M&A Handbook and the EDGAR-Online Guide to Decoding Financial Statements.
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