The Practical Investor always looks for reliable short cuts to decide
how much to pay for an investment opportunity that presents itself. Short
cuts are easily found in widely used technical appraisal formulas. But overall,
valuation is non-technical and all about RISK, and often represented by
the human equation: P x S x E = V; where P = problem, S = solution, E =
entrepreneurial team, and V = valuation.
In Revenue Ruling 50-60, the IRS standard for fair market valuation is
based on the buyer and seller both having reasonable knowledge of relevant
facts and neither being under compulsion to buy or to sell. Consequently
most valuations bypass human factors and use common technical formulas such
as:
- Discounted Cash Flow Method (used with companies with existing or projected
cash flows)
- Ratio Method (one of the roughest of methods, but a basic sanity check,
found in studies such as published by Robert Morris and Associates)
- Venture Capital Method (used with companies not expected to go out
of business having either a negative cash flow or a long period for significant
earnings)
- First Chicago Method (company actual and expected cash flows are weighted
and averaged for three possible scenarios)
How do these formulas get applied? Every year there are about 2.5 million
"big ideas" and about one-fifth or about 500,000 become spelled
out as business plans. Taking it to the next step, in 2004, venture capitalists
funded fewer than 3000 companies (and then only 791 were first time financings),
or about 3 in 500. Angel investors funded over 48,000 companies, or about
1 in10.
So what detracts from enterprise value? Here's a hit list of top factors
and the questions they raise.
- Small-scale operations. Why is it small? Can it be made large?
- Weak access to supply and distribution markets. Management problem
or fundamental in the economy?
- Long development times. Product related? Labor related?
- Short performance history and uncertain growth rates. Is it worth the
risk?
- Unproven management. Inexperience of youth? Lack of knowledge of the
business?
- No collateral. Are there alternatives for investment recovery besides
the business plan targets? Is it worth the risk?
- High transaction cost for the investment size. Do you have to purchase
a $5,000,000 rocket to orbit a $10,000,000 satellite?
- Low survival rates. How many rockets make it to orbit?
- Innovation coupled with other high-risk factors. Is the new French
nuclear reactor design really safer? Since no nuclear reactors in the U.S.
have been built in the last 40 years, can this one be built?
- Illiquidity. If the investment fails to achieve the upper level of
projections, will it take months, years or decades to be acquired or become
a public company?
Books have been written about every sentence in this article. The Practical
Investor has to have a place to start and the above ideas are the crucible
of formation. |
