IPCPL and Margin Reversion: Implications for the Valuation of Small Privately Held Companies

The Implied Private Company Pricing Line (IPCPL) model is a consistent market-implied approach to measure the cost of capital for private companies. Its key element is the cost of capital for the smallest private companies, derived from Pratt’s Stats information on the acquisition prices and the companies’ financials. When these companies were aggregated, they collectively appeared to be in a steady state, which allowed the authors of the IPCPL model to estimate the cost of capital from the Gordon formula. The purpose of this paper is to analyze the pricing of individual small privately held companies to check whether it is consistent with the two concepts: the IPCPL cost of capital and the finiteness of the competitive advantage period, which, other things being equal, should, over time, lead to the profit margin convergence to the market mean over time and companies with mean margin being valued as steady-state companies, while companies with margins lower (higher) than the market to be valued higher (lower) than predicted by the Gordon formula because of the margin reversion effect. The market valuation of individual small privately held companies proved to be consistent with both concepts. Companies with margins close to the mean were valued with price-to-sales (P/S) multiples consistent with the IPCPL cost of capital, and the valuations of the rest of the companies were in line with the margin reversion effect.¹