Contextual Factor Analysis

A value of a business is influenced by a host of factors, which are both qualitative and quantitative. An entrepreneur must take into consideration all these factors before determining the value of his/her venture. It is sometimes known as CONTEXTUAL FACTOR ANALYSIS. It simply means what is the general context in which the valuation is taking place?

Some of these factors are identified as follows: Refer to the end for a brief discussion

The historical, present, and projected cash flow of the firm

Who is valuing the company?

Is it a private or public firm?

The availability of capital

Is it a strategic or financial buyer?

At what stage is the entrepreneurship?

The state of economy.

The reason the company is being valued.

Tangible and intangible assets.

The industry - its current situation

There are several methods to value an enterprise. Further everyone looks at the valuation in its own way.

1. Comparative Approach

Here the similar companies in the industry or even companies, which have been bought and/or sold, are identified and similar value is then assigned to the enterprise to be valuated.

2. Present Value of Future Cash Flows:

This is a widely used technique and this method adjusts the value of the cash flow of the business for the time value of money and the business and economic risks. In this method sales and earnings are projected based on certain assumption of the evaluator. These then are discounted at a desired rate of return. Many adjustments can be incorporated in the technique to make it as accurate as possible.

3. Replacement Value:

This type of method is used only by the insurance companies or in some unique circumstances. This method concentrates on the valuation of how much it will cost to replace or reproduce an asset of the venture or any important asset or system of the venture.

4. Book Value:

It is the worth of the net tangible assets of a company. This method is used mostly when the venture is relatively new and does not have a record of earnings. It is also used for valuing a speculative business. It is not necessarily considered accurate. The procedure is as follows:

Book Value

Add (subtract) appreciation or depreciation to arrive at the fair market value.

Subtract any intangibles such as goodwill. This is Adjusted Book Value of the company.

5. Earnings Approach:

Also known as the P/E method, it utilizes the possible earnings the company can earn after adjusting for an extra ordinary expenses that would not normally occur in the operation of the business. An appropriate P/E multiple is used and is multiplied to the adjusted earnings to arrive at the value of the firm. The multiple chosen must be appropriate for firms in that specific industry

6. Liquidation Value:

This is the lowest value of a business being valued. It is really difficult to obtain simply because it is difficult to place a value on inventory, terminating employees, account receivables, and other assets. However, it at least offers a downside risk value of the enterprise.

VALAUTION FOR VCs - A special case of valuation

It is necessary for the entrepreneur to determine how much of the company he will receive for the amount of investment. This is done as follows:

Venture capitalist ownership in percentage =

VCs investment x VCs investment multiple desired/Company's projected profits in the year VC wishes to harvest x P/E of a comparable company.

Example: A venture needs $1,000,000 from a VC, The Company's projected profits are $1,100,000 and P/E of a similar company is 12. The VC wants an investment multiple of at least 5 times.

Percent ownership = 1,000,000 x 5/1,100,000 x 12 = 37.9

Or the entrepreneur has to give up 37.9 percent of ownership to obtain the needed funds of one million dollars.

A more sophisticated method takes into consideration the present value.

If the VC wants to harvest at the end of year 5, and if we assume that the net after earnings will be $1.1 million and the P/E is 12, then the value of the enterprise at the end of 5 years is 1.1x12 =13.2 million. Present value of that value at a required rate of return, say 26 % will be 0.4019x13.2 = 5.3 million

VCs share = Initial funding/ present value of the earnings

= 1.0/5.3 = 18.9% '

A detailed look at some of the above techniques

NPV or DCF valuation:

A firm has both equity holders as well as debt holders; hence the value of the firm depends upon cash flows to all of these claim holders.

The concept of Free Cash Flow to the firm is used and it is the cash flow left over after operating expense, taxes and reinvestment needs are met.

Free cash Flow to the Firm= After-tax Operating Income -Reinvestment Needs

What is the concept behind it? Or what does Free Cash Flow to the Firm measure? It measures the cash flows generated by the assets before any financing costs are taken into account. This is the cash flow used to service all claim holders including interest principal to debt holders and dividends and stock buy-backs to equity holders.

There are some missing pieces that must also be considered. One of them is the value of any asset that has not been valued in the cash flow technique. These generally include cash, marketable securities and other non operating assets. The second is the value of equity options issued by the company that could affect the value of equity pr share. The last one is to value voting rights. This you will have to do only when the shares have different voting rights. Generally