One of the issues I am often asked about in relation to Private Equity is valuation. This is a big subject, but I will try and cover the basic principles – these are all things you should be aware of – and able to discuss knowledgeably – if interviewing for a PE role.First, I will be talking here about a straightforward invest-develop-sell approach to PE – some more complex strategies may use different criteria, but we are simply talking about the process of putting a value on a business, growing/developing it over a number of years with a view to selling it at a profit in the future.PE investors will have a benchmark rate of return for their funds. It is generally accepted that PE investing is higher risk than investing in listed equities, which is itself higher risk than investing in, say, government bonds; the benchmark will need to reflect this and also any other specific risks that may be associated with the investor’s strategy. It is a rate of return that they will have marketed to the investors in their fund. Any investment they make will have to have the potential, in their view, to achieve or beat this benchmark rate.This benchmark rate is usually expressed in terms of IRR – the Internal Rate of Return. IRR is effectively the discount rate at which all the cashflows from an investment have a net present value (NPV) of zero. For example, if you invest $10m at the outset, receive four years of dividends of $0.5m and sell the investment in year 6 for $25m, you can calculate the IRR of the investment, which in this case comes out at 23%.A manual calculation of IRR is complex, but Excel makes it quite simple. It does have drawbacks - the precise timing of cashflows can have a big impact on the outcome (different timings can be modelled in Excel, but in reality these are hard to forecast with accuracy). Its great advantage, however, is that it takes into account the time value of money.As we have seen in the above example, there are typically three forms of cashflow involved in a PE investment: the investment itself (an outflow of cash from the point of view of the investor), inflows during the lifespan of the investment (usually in the form of dividends) and an inflow upon the sale of the investment. An investor will forecast dividends and exit price, but the one cashflow over which he/she has complete control is the price they pay, so getting this right is fundamental to the success of an investment.Obviously for a transaction to take place, there needs to be both a willing buyer and willing seller, so agreeing price and terms is an iterative process of negotiation. It is incumbent upon the investor to ensure that they do a full and proper analysis to ensure that the price paid will allow them to meet their return benchmark.In many cases, the seller will be the founder of a business who is looking for capital to grow their company (a primary transaction where new shares are sold to the investor, bringing capital into the business, but diluting the existing shareholders). In this scenario, the seller is often emotionally attached to their business, believes passionately in its potential and may not be particularly financially sophisticated. All of this can complicate the process of agreeing a suitable price. The investor may need to be patient, explain their reasoning and be prepared to step away from a transaction. It may also be possible to bridge the gap in valuation expectations by structuring the transaction with mezzanine instruments and options (potentially the subject of another post…).So how is a valuation set? There are many variables that can be used. For an established business, comparisons can be made with equivalent listed companies using a variety of different measures such as enterprise value to EBITDA or price to book value, the relevance of which will be determined by the nature of the business. For a younger less established business (as would be the case in Venture Capital investing) different methods have to be used.In any scenario, the investor will need to model the expected trajectory of the company’s financial performance. In the case of young companies in particular, this will usually involve taking management forecasts and performing reality checks, stress-testing and scenario analysis (bearing in mind, of course, that the management are likely to have a rosy view of their prospects!). This will allow the investor to form a view on the likely exit price they can achieve, based on their investment time horizon. With this information, they can reverse engineer the investment’s potential IRR based upon different entry valuations and calculate the maximum price that they would be prepared to pay. The rest comes down to negotiation.