Market Watch

Public vs. private markets: Don't confuse the two

Jerry Grossman

These are heady days in public equity markets for federal information technology and defense stocks. For owners and executives at privately owned defense companies, a correct interpretation of pricing behavior in the public markets is essential.

Within most industry sectors, public market company valuations are not necessarily indicative of private market values. Pricing for public government technical services companies, such as CACI International Inc., ManTech International Inc. and Anteon Corp. ? and soon Veridian Corp. and SRA International Inc. ? is quite robust relative to history, reflecting current public investor sentiment. Private market values, alternatively, reflect the assessments of industry operators, debt-capital sources and seasoned private equity partners.

One of the fundamental reasons that public companies' valuations can soar beyond private companies' valuations is the difference between public and private investors.

It's often true that investors in publicly traded companies are buying stocks, while private company investors are buying companies. The inherent liquidity in a position of, say, 100 to 1,000 shares, in an actively traded public company allows investors to move in and out of their investment position quickly and at low cost. Their holding period is often days, weeks or months ? very short term.

Conversely, buyers and investors in private companies have a much longer investment horizon and, in fact, cannot liquefy their positions expeditiously. Their holding period is measured in years: at least one year, and frequently five years or more.

Public investors watch quarterly results closely, while private company investors generally are concerned with building value and increasing results over a longer period. Other differences exist, both between private and public investors as well as between public and private companies. A privately held company shouldn't focus too much attention on industry stock market valuations, unless it's considering an initial public offering.

Additional perspective can be gained by comparing the operating performance trends of public companies with the trends in their market pricing and price performance ratios.

This comparison demonstrates that, while some pricing movement is driven by performance or expectations, pricing levels in public markets are often impacted by other factors. For example, the variation in price-to-performance ratios for government services companies was two to four times the volatility of operating performance from 1990 to the present. In the early 1990s, $1 of industry revenue was worth 25 cents, and $1 of earnings before interest, tax, depreciation and amortization (EBITDA) was worth about $3 to $4.

Presently, $1 of industry revenue is valued at $1 to $1.25 by public investors, four to five times the ratio of the early 1990s. Similar expansion in the value of each dollar of EBITDA has occurred.

Performance as measured by profit margins, revenue growth and balance sheet management has improved for well-managed companies by 20 percent to 30 percent or more. Arguably, for certain companies, long-term growth rates have increased by 20 percent to 30 percent.

Adding lower costs of capital to the mix suggests that doubling price-to-performance ratios seems realistic. Doubling acquisition transaction multiples over the past 10 years, occurring in strategic sales and private equity deals, correlates much more closely to improvements in industry performance than today's public market pricing ratios.

For companies raising capital to grow or considering a sale, nothing is more important than a sound, thorough understanding of investor sentiment, strategic buyer criteria, tiered transaction pricing and transaction process elements. Successfully completing these initiatives is not a benign exercise, as it impacts upon employees, executives and owners. Plan carefully. Get good advice.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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