Practical analysis for investment professionals
26 January 2016

A Valuation Method for Private Equity

Anyone who has created valuation models knows that there are certain types of businesses that challenge traditional methods. One classic example is the private company, which has long posed problems for evaluators. But a new firm, FEV Analytics, has developed a proprietary method for valuing such entities and is directing its product at the private equity space. As this interview with cofounder Sheridan Porter indicates, FEV’s approach can inform the valuation of publicly traded firms, too.

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CFA Institute: Tell us a little bit about FEV Analytics. What is the main idea behind the firm?

Sheridan Porter: FEV Analytics is an independent data science company located in Seattle, founded in 2013. We have developed the market’s first objective, accurate (R2 of FEV to firm value is 0.813), and consistent measure of private firm performance and risk.

The main idea behind FEV Analytics is to use the FEV measure to improve systemic inefficiencies within the private equity industry.

Interesting. Tell us a bit more about how the sausage is made. For example, what is an FEV measure? What are some of the elements that go into yours?

FEV stands for fundamental economic value, and is the value of an asset’s economic engine. It is conceptually similar to an intrinsic value but differs in that it is produced using only an asset’s industry classification and financial fundamentals as inputs. The analysis involves no forward-looking inputs or assumptions, so it is 100% objective, repeatable, and automated.

Inside the sausage is a mathematical framework that draws from biological size and growth models to explain the multi-scale relationship between financial fundamentals and asset value by industry. Independent academic testing has confirmed that the FEV model is equally accurate for big, small, public, and private companies.

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Why does FEV focus on the private equity space?

We decided to focus on private equity ahead of debt or public equities because PE is where the need is most urgent and where our products are uniquely impactful. The absence of a mathematically sound model and objective measure has resulted in inefficiencies that cost investors billions every year. FEV makes more frequent, more granular monitoring economically feasible. FEV’s model allows benchmarking to finally be put to work, made CFA Institute compliant contemporaneously, and synchronous with public markets. The right instrumentation is potentially transformative to the industry, but importantly to us (and why we got into this business), it can sharpen the focus on what actually matters — managing the growth of individual businesses.

What’s the weighted average time embedded in the data? Because you are using historical data, each company has differing amounts of historical data. So how far, on average, is that look back? How does this affect the valuations you develop?

Year 1 and Year 5 would be weighted exactly the same: zero. For each valuation, the model looks at one [corresponding] set of trailing 12 month financials. So today’s value of the hypothetical company would be computed from a set of trailing 12 month financials dated today.

How does your model deal with fluctuating premiums?

An excellent question. The FEV model has stripped out the premium, so theoretically FEV is separated from market price by market premium. Because the FEV model crosses the public/private boundary, we can take advantage of public company information to understand where the premium is at any given time. We can measure the premium of the market as a whole, or a subset — all the way down to a single asset. To increase the specificity of the premium to a given private asset, we create a custom public benchmark — typically comprising around 50 stocks — using the private asset’s FEV (size) and industry as the primary criteria. Then we measure the benchmark’s premium, synchronous with the date of the private asset’s financials, and map that information back to the private asset. So, the benchmark process that we use is instrumental in dealing with fluctuating premiums, applying the insight they bring. They also need to be created in an objective way, and we’ve invested in developing tools to optimize their robustness, preserve objectivity, and automate the entire process.

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You quote an R2 of 0.813. What is the confidence interval around that? Also, presumably that R2 represents an underlying positive correlation, yes?

99% confidence interval:               0.81010 ≤ R2 ≤ 0.81590

95% confidence interval:               0.81080 ≤ R2 ≤ 0.81520

90% confidence interval:               0.81115 ≤ R2 ≤ 0.81485

Where k=15, n = 90000, R2 = 0.813 (for the independent validator’s data set)

Yes, the R2 represents an underlying positive correlation.

A large part of your marketing emphasizes the bias-free nature of FEV Analytics. What does “bias free” mean to you?

To me, bias free has both a statistical meaning and a methodology meaning. FEV’s methodology excludes subjectivity. Data inputs are taken from financial statements, so there’s no setting or variable that requires judgment, for example, a discount rate or — even more nuanced — the purpose of the valuation. Statistically, bias free means that the residuals have mean approximately 0 and a symmetric random distribution. (This is true in log space). This means that error or noise isn’t compounded as the portfolio size increases. In fact, FEV becomes more accurate since the errors diversify away.

Importantly, FEV’s bias-free approach provides repeatability, which in turn makes comparison possible, even across traditional boundaries such as industry and vintage year.

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Our last question, a two part one: Say a genie appears out of a magic lamp and grants FEV a wish about its relationship to the private equity space. For what does FEV wish? And tangent to that question, what evolution remains to occur with the quality of FEV’s offerings?

We’d wish for FEV to be the standard measure in the private equity space. Since measurement affects behavior, the industry would evolve to be a more efficient allocator of capital, more engaged in value creation, with less “dark space” between LPs and GPs. Because FEV can measure through the j-curve, we’d give the industry the tools to be strategic long-term investors — able to put capital to work on grand challenges as well as making returns.

Right now we’re seeing a lot of interest in measurement, particularly performance attribution, but the mechanism to tie that measurement into better decision making about future investments and risk management is not a mature process for most investors. We see our products evolving along with the industry to support a common framework that incorporates asset allocation and risk management smoothly across both liquid and illiquid assets, truly unifying the portfolio.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/retrorocket

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

10 thoughts on “A Valuation Method for Private Equity”

  1. EdP says:

    If valuation is a forward looking exercise his dies using just inputs based on history become the basis for the future?

    1. Hello EdP,

      Actually the time period for a valuation is up to the analyst. For example, could you not calculate the value of a non-publicly traded company that went bankrupt during the Great Depression? Yes. Could you not calculate the value, not to a present value, but an estimate of what you believe a company is worth in 6.3 years because you are valuing the options extended to executives? Yes. You can also calculate the present value of the asset, which is what most people calculate in a valuation.

      But FEV analytics does not project a future and then discount it back to the present. Instead they use historic information to assess present value. In fact, when I was a portfolio manager I used to play around with valuing companies based solely on their historic results. The point is that there are lots of ways to derive valuation. The question is whether or not the model you are utilizing is borne out by reality, ultimately.

      Yours, in service,

      Jason

  2. John Vardavas says:

    Based on the limited information in the interview, it would seem that there is little regard for forward looking data. I think this model would have very limited applications. I don’t doubt that the model is done very well, but without an emphasis on forward looking data, I think you could be missing the valuation boat!! Their website claims, “…FEV is the most accurate model.” I never realized a contest took place and they won? What other models competed and who were the judges? I guess all of us ABVs and ASAs are now out of business without this model? I am wary of a valuation model that uses a black box approach. If they are correct, they should be able to use this data on public companies and become billionaires in a relatively short period of time by investing off their own research? Am I missing something here?

    1. Hello John,

      Thank you for sharing your criticism of the model. I don’t think you are missing anything based on FEV analytics’ public disclosures. Their methods are proprietary and black box. We cover firms promulgating new solutions because harried investment folk rarely hear about some of these new technologies and new firms offering them. See, for example, my articles covering XBRL and firms making use of that data. As with any new offering, nothing beats your own due diligence.

      Yours, in service,

      Jason

  3. Matheus Schneider says:

    Hi Jason,

    I am highly interested in getting in touch with Sheridan, for business purposes. How can I get in touch with her?

    Warm regards,

    Matheus Schneider

    1. Hello Matheus,

      I just sent you Sheridan’s e-mail address privately.

      Yours, in service,

      Jason

  4. Krzysztof Kajetanowicz says:

    OK, this is an algorithm they’re keeping in a black box, and yet:

    “We’d wish for FEV to be the standard measure in the private equity space.”

    Right. I don’t care how good this formula is (and I wonder if they have a way of proving their numbers – the R squares haven’t been explained in any sort of detail, and is this verifiable?). PEs using black boxes (which they can’t look into) to value their portfolios for any meaningful purposes? Never. Gonna. Happen.

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