When valuing private companies, normalized earnings are appropriate. However, in this context, normalized earnings refer the earnings of the company if it were acquired, instead of an averaged earnings over time.
Normalized earnings of a private company should exclude nonrecurring and unusual items. Private companies can take on tax motivated expenses for instance, pay directors and family members inflated wages or use company assets for personal motivations. In poorly performing firms, the opposite may hold, and earnings may have to be normalized lower.
Some analysts will remove any income and expenses from real estate on the income statement as real estate may want to be treated differently from the rest of the business’s operations given its potentially different risk, growth and accounting profile.
When estimating normalized earnings for a strategic transaction, the analyst should incorporate any synergies as an increase in revenues or as a reduction in costs.
Analyzing the cash flows of a private firm is also a challenge. When there is significant uncertainty about a private company’s future operations, the analyst should examine several scenarios when estimating future cash flows. For development stage firms, scenarios could include a sale of the firm, an IPO, bankruptcy, or continued private operation. For a mature firm, scenarios might include different ranges of cash flows based on different assumed growth rates.
Although analysts use FCFF or FCFE depending on the purposes of the valuation, FCFF is usually more appropriate when the significant changes in the firm’s capital structure are anticipated.