A Lower Cost of Capital

When investment professionals discuss the benefits of taking a company public, they often home in on the lower cost of capital.

Historically, price/earnings valuations have been higher in the public market than in the private market, explains Kevin Silverman, a retail analyst at Chicago-based ABN Amro Asset Management. This is primarily because of the value investor put on liquidity. Every $1 worth of earnings from a public company might be valued at roughly $15. In comparison, every $1 in earnings from a private company would more typically be valued at $10.

This discrepancy explains how some public companies become so large. Let’s say a publicly traded company with $1 in earnings decides to buy a privately held company that also has $1 in earnings. The public cataloger pays $10 worth of stock for that $1 in earnings. Now it has $2 in earnings. But the public market is willing to pay 15 times earnings for this company. So the company’s $2 in earnings is now worth $30. In other words, the public company enjoyed a 50% return on investment on the $10 it paid for the private firm.

“A private company,” Silverman says, “could not possibly engage in this type of roll-up strategy, which has historically been the arbitrage between public and private market valuations.”