Table of Contents
How Private Equity Values Target Companies
- CLFI Team
- 7 min read
Private equity investors assess hundreds of opportunities each year, yet only a small fraction progress to active bidding or acquisition. A central step in this filtering process is valuation, which converts a company’s business plan, financial data, and underlying risks into a view of economic worth. Valuation does not begin with spreadsheets, but with an understanding of what drives long-term performance in the target. It then evolves into a structured analysis of revenue, margins, cash flow, debt capacity, and comparable market evidence. This article explains how private equity firms value companies, how those approaches differ between early-stage and mature businesses, and how the results feed directly into investment decisions. Throughout, we use a fictional company, LBS City Ltd, to illustrate the mechanics.
Why Valuation Matters in Private Equity
Valuation is one of the most visible components of an investment decision, yet it sits on top of a much broader assessment of strategy, capability, and risk. A private equity fund aims to buy an asset, improve its performance through operational and financial measures, and eventually sell it for more than the original investment. The valuation of a target company therefore feeds directly into expected returns because it sets both the entry price and the expectations for exit value. When the valuation is overstated, the fund risks compressing returns; when it is understated, the fund may be excluded from competitive processes.
In practice, valuation evolves as information deepens. Initial reviews rely on limited data and broad industry assumptions. More detailed work begins during preliminary due diligence, where investors scrutinise revenue drivers, working capital patterns, capital expenditure needs, and potential downside scenarios. These insights influence both the multiple that investors are willing to apply and the capital structure they consider appropriate.
Programme Content Overview
The Executive Certificate in Corporate Finance, Valuation & Governance delivers a full business-school-standard curriculum through flexible, self-paced modules. It covers five integrated courses — Corporate Finance, Business Valuation, Corporate Governance, Private Equity, and Mergers & Acquisitions — each contributing a defined share of the overall learning experience, combining academic depth with practical application.
Chart: Percentage weighting of each core course within the CLFI Executive Certificate curriculum.
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The Private Equity Valuation Toolkit
Most private equity valuations begin with a multiyear business plan that translates the company’s strategy into financial forecasts. Investors construct their own version of this plan, informed by management input and due diligence findings. They build base, downside, and upside scenarios and assess whether the company’s risks align with the fund’s mandate. These scenarios form the foundation for valuation techniques, which vary according to the target’s maturity.
Definition:
Enterprise Value (EV)
Enterprise value represents the economic value of the entire business, calculated as the value of its operations before considering the impact of its financing structure. Equity value is derived by subtracting net debt from EV.
Valuing Early-Stage Companies: The Venture Approach
Early-stage companies, particularly those at seed or Series A stage, often have little or no profit history. LBS City Ltd illustrates this challenge. In its early years, the company had a developing analytics platform, a handful of pilot customers, and modest recurring revenue. In this type of situation, investors cannot rely on past cash flows. Instead, they focus on where the company could be in several years if the plan works. Venture investors therefore start from a future target value and then work backwards to what the business should be worth today, given the risk they are taking.
Venture Valuation: Post-Money, Pre-Money and Ownership
Walking through how a future exit value turns into today’s valuation and investor equity.
Early-stage investors usually start with three simple questions: How big could this company become?, what do similar companies trade for?, and what return do we need for the risk involved? The combination of those answers leads to a valuation today for LBS City Ltd.
| Projected Revenue in Year 5 | £20m |
| Comparable Forward Sales Multiple | 2.0× |
| Implied Exit Value (Year 5) | £40m |
| Investor Target IRR (Required Annual Return) | 60% |
The first two lines answer the question, “How big could this be?”. If LBS City Ltd reaches £20 million of revenue in five years, and similar listed or acquired companies are worth around 2 times that revenue, then a reasonable future exit value is about £40 million. This is not a guarantee, but a working estimate of where the company could get to.
The next question is, “What return do investors need?”. Early-stage companies fail more often than mature ones, so venture investors usually demand a high target return. Here, they require around 60 percent a year. In simple terms, they ask: “What amount would we need to invest today so that, if it grows at 60% per year for five years, it becomes £40m?” The answer to that question is the post-money valuation today, which is approximately £4 million.
Now we connect that valuation to the fundraising round. If LBS City Ltd is raising £1 million today and investors agree that the company should be worth £4 million just after their money goes in, then: the post-money valuation is £4m, the pre-money valuation is £3m (which is £4m minus the new £1m), and the new investors own 25 percent of the company (their £1m divided by the £4m post-money value).
Put differently, the investors believe that a £1m investment for a 25% stake is fair because, if LBS City Ltd reaches £40m in value in five years, their 25% could be worth about £10m. The whole structure is driven by three ingredients: a future revenue and exit value estimate, a required annual return that reflects early-stage risk, and the size of the cheque written today.
Valuing Mature Companies: Growth Equity and Buyouts
A step-by-step look at how EBITDA multiples and debt create equity returns in a leveraged buyout.
As LBS City Ltd matures, investors no longer work in the dark. They can see several years of revenue, profit margins, and cash generation. At this stage, growth equity and buyout investors usually start from an EBITDA multiple to get a market-based value for the whole business. This helps them compare LBS City Ltd with other similar companies, regardless of how those companies are financed or taxed.
We now walk through how a leveraged buyout (LBO) structure works using LBS City Ltd. The company currently generates £4 million in EBITDA, and comparable companies in the market are trading around a 7× EBITDA multiple.
| Current EBITDA | £4.0m |
| Entry EBITDA Multiple | 7.0× |
| Debt Capacity (as multiple of EBITDA) | 3.5× |
| Projected EBITDA at Exit (Year 5) | £6.0m |
Calculate Enterprise Value at Entry
Enterprise Value (EV) represents the value of the entire business as if it had no debt and no cash. It answers the question, “What is the company as a whole worth?” To find EV here, investors take the current EBITDA and multiply it by the market multiple.
| Calculation Component | Value |
|---|---|
| EBITDA | £4.0m |
| Entry Multiple | 7.0× |
| = Enterprise Value | £28.0m |
The calculation is straightforward: £4m × 7 = £28m. This £28 million Enterprise Value is the headline price for LBS City Ltd as a business, before deciding how much of that price will be paid using bank debt and how much will be paid using investor equity.
Determine the Capital Structure
In a leveraged buyout, investors do not pay the full price in cash from their fund. They aim to use some bank debt, which is then repaid over time from the company’s cash flows. Here, the market believes that LBS City Ltd can safely carry debt equal to 3.5× its EBITDA.
| Financing Source | Calculation | Amount |
|---|---|---|
| Debt Financing | £4.0m × 3.5× | £14.0m |
| Equity Contribution | £28.0m − £14.0m | £14.0m |
| = Total Sources | £28.0m |
Out of the £28 million total price, £14 million comes from lenders and £14 million from the private equity fund. This 50/50 split means that equity investors only put up half of the purchase price, yet they own 100% of the company’s shares. The borrowed half must be repaid over time, which is why the company’s ability to generate stable cash flow is so important.
Project Exit Value at Year 5
The final step is to think ahead to the sale of LBS City Ltd in five years. Suppose management and the investor plan to grow EBITDA from £4 million to £6 million. If the market is willing to pay the same 7× multiple at that point, the exit Enterprise Value is calculated in the same way as at entry.
| Calculation Component | Value |
|---|---|
| Exit EBITDA (Year 5) | £6.0m |
| Exit Multiple | 7.0× |
| = Exit Enterprise Value | £42.0m |
| Less: Outstanding Debt (assumed paid down) | (£14.0m) |
| = Equity Value at Exit | £28.0m |
By Year 5, the business is worth £42 million. If the remaining debt is £14 million, the value left for shareholders is £28 million. Equity investors started with £14 million and finished with equity worth £28 million. That is a 2.0× multiple of money, which works out at roughly a 15% annualised return over five years.
Learning Takeaway
This example shows how EBITDA multiples and leverage combine to shape private equity returns. The calculations are simple, but the story they tell is important.
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Definition:
Risks of Debt and Private Credit
Debt introduces fixed obligations that reduce financial flexibility, increase insolvency risk, and amplify losses when performance deteriorates. These risks are particularly visible in the fast-growing private credit market, an opaque segment of the shadow banking sector, where loans are issued by non-bank institutions that face minimal regulatory scrutiny.
Recent failures highlight how excessive borrowing can trigger wider financial instability. The collapses of US firms First Brands and Tricolor resulted in substantial losses for regulated banks exposed to their private credit financing, including Jefferies (reporting a $715m exposure) and JP Morgan (recording a $170m loss). These cases demonstrate how debt-supported business models can quickly unravel, with losses spreading beyond the original borrower.
The broader private credit industry is dominated by major alternative asset managers such as Blackstone, Apollo, Ares, and KKR. Their lending activities often sit outside traditional regulatory frameworks, limiting transparency and preventing regulators from assessing the true value and risk profile of underlying loans. This opacity increases the likelihood that problems remain hidden until defaults occur, at which point both borrowers and lenders may face sudden and severe financial stress.
In practice, high leverage restricts a company’s capacity to invest, weakens operational resilience, and heightens the probability that even moderate earnings volatility leads to covenant breaches or failure. When combined with the opaque nature of private credit markets, the use of debt can generate systemic vulnerabilities that affect banks, investors, and pension funds linked to these structures.
Understanding Valuation Multiples
Multiples provide a market-based reference point for valuing companies. They compare enterprise value to an operating metric, allowing for comparisons between businesses with similar characteristics. The most common multiple in private equity is EV/EBITDA because EBITDA approximates operating cash flow and reduces distortions arising from capital structure. Other multiples, such as EV/sales or EV/book value, are used when profitability is limited or the company operates in asset-intensive sectors. The challenge lies in selecting a comparable set that accurately reflects the target’s business model and risk profile.
In practice, investors use both historical and forward multiples. Historical multiples capture recent performance and may provide stability; forward multiples incorporate expected improvements but rely on forecast accuracy. A balanced approach reduces the risk of overpaying when optimism is high and underpaying when the market undervalues future growth. For LBS City Ltd, investors would analyse peers across analytics and software markets, isolating those with similar margin profiles and customer concentration exposure.
In Practice: What Executives Should Take Away
In practice, valuation shapes negotiation strategy, capital allocation decisions, and board-level discussions. Executives should understand how multiples reflect risk and growth expectations, why investors adjust for debt capacity, and how scenario analysis influences pricing. They should also recognise that valuation does not determine the final purchase price, which is influenced by competitive dynamics and non-financial factors such as speed, certainty, and alignment with the seller’s objectives. A clear grasp of how private equity values companies enables leaders to engage more effectively with investors, articulate operational plans with impact, and anticipate how their performance will translate into economic value.