Discounted Cash Flow Valuation

If you've ever tried raising money for your startup, you've likely been asked, "What’s the valuation of your company?" It’s a critical question, and you can't just pick a number that sounds good.

You need a clear process to show how you arrived at that valuation, using both qualitative and quantitative data.

It is crucial because investors need a reliable way to assess a company's future potential and translate that into a fair valuation. This is where valuation methods like the discounted cash flow help. They provide the necessary evidence and logic behind your company's worth, helping to justify the number you present to investors.

What is Discounted Cash Flow (DCF) valuation?

Discounted Cash Flow (DCF) valuation is a method used to estimate the intrinsic value of a company by considering all the future cash flows it is expected to generate and discounting them back to their present value.

Let’s break the above sentence down:

1. Future cash flows

‍This refers to the projected amount of money a company is expected to earn in the future, typically over a period of several years.

‍2. Discounting‍

Since a dollar today is worth more than a dollar tomorrow (due to the time value of money), DCF uses a discount rate to convert future cash flows to their present value.

‍3. Intrinsic value

‍This is the theoretical value of an investment based on its future earning potential. 

By considering these factors, DCF helps investors arrive at a more objective valuation of a company compared to relying solely on intuition.

Applications of discounted cash flow valuation

Figuring out a company's valuation is the main goal of DCF, but the steps to get there can also reveal a lot of useful information that can be applied in many ways:

‍1. Securing investment

The first and most important use case of DCF is when companies are looking to raise money. 

Investors rely on a data-driven approach to assess a company’s potential. DCF valuation helps companies present a well-researched argument for their valuation, considering future growth prospects. This can increase their credibility and attractiveness to potential investors.

‍Example: Imagine a food delivery app company, "Foodie on the Go," projects to generate $1 million in revenue next year and grow at a rate of 30% for the next five years. Using DCF with a reasonable discount rate, Foodie on the Go can present a valuation that reflects their anticipated future earnings potential, making them a more compelling investment opportunity.

2. Internal planning and goal setting

The DCF process itself forces entrepreneurs to think critically about their future cash flows. This can be a valuable exercise for internal planning and setting realistic growth goals. By analyzing different scenarios with varying assumptions, companies can create a roadmap for achieving financial sustainability.

Example: An electric scooter startup, "Scoot Around," uses DCF to analyze the impact of different pricing models and marketing strategies on their projected cash flow. This helps them identify the most sustainable path towards profitability.

3. Benchmarking and competitive analysis

By applying DCF to publicly traded competitors, companies can gain insights into their relative valuation based on projected growth. This allows them to understand their position within the market and potentially adjust their own strategies.

Example: A social media analytics startup can use DCF to analyze the valuation of established social media companies. By comparing their own projected growth trajectory, they can assess if their current valuation aligns with their position within the competitive landscape.

‍4. Mergers and Acquisitions (M&A)

In the event of a potential acquisition, DCF valuation can provide a defensible starting point for negotiations. It helps companies demonstrate their intrinsic value based on future earning potential, not just current assets.

Example: A biotech startup, "Green Cure," is in acquisition talks with a larger pharmaceutical company. Green Cure can leverage their DCF valuation, highlighting their projected cash flow from a new drug launch, to secure a more favorable acquisition price.

Pros and cons of DCF valuation

While the discounted cash flow method offers valuable insights, it also has limitations to consider. 

Pros:

1. Explicit consideration of time value of money

DCF explicitly factors in the time value of money, providing a more realistic valuation compared to methods that don't (e.g., price-to-earnings ratio).

2. Focuses on future potential

DCF goes beyond the current market price and analyzes a company's projected cash flows, providing a more forward-looking perspective on its worth. This is particularly beneficial for companies with high growth potential.

3. Explicit assumptions

The DCF process requires explicit assumptions about future cash flows, discount rate, and terminal value. Terminal value refers to the estimated present value of a company's cash flows beyond a specific forecast period. This transparency allows for scrutiny and discussion, fostering a more informed valuation process.

4. Detailed and customizable

Unlike a price-to-earnings ratio (P/E) that just looks at a single metric, DCF lets you plug in different financial measures like future sales growth or profit margins. 

Imagine a company considering a new product line. DCF can analyze the projected sales and expenses over several years, helping investors decide if the investment is worthwhile.

5. Market-independent

DCF valuation is independent of the current market sentiment. It focuses on the company's fundamentals, making it a valuable tool when market prices might be distorted by short-term trends.

Cons:

1. Reliance on assumptions

The accuracy of a DCF valuation hinges heavily on the assumptions used. Inherently uncertain factors like future growth rates and discount rates can significantly impact the final valuation.

2. Complexity and time-consuming

Performing a thorough DCF analysis requires expertise and can be time-consuming. Projecting future cash flows and selecting appropriate discount rates involve complex calculations.

3. Limited comparability

While DCF excels at digging into a single company's future potential, it doesn't directly tell you how it stacks up against competitors. 

Imagine you're valuing a tech startup. A DCF analysis can tell you if it has the potential to be profitable, but it won't say if it's a better investment than another promising startup in the same space. To get a more complete picture, DCF is often combined with comparisons to similar companies' market valuations.

4. Ignores market psychology

DCF prides itself on being independent of the current market sentiment. But imagine a company in a hot industry, like electric vehicles. A DCF analysis might predict steady growth based on its own fundamentals, but it wouldn't necessarily capture the excitement of investors driving up the valuations in the short term. 

So, while DCF is great for understanding a company's intrinsic value, it's wise to consider broader market sentiment for a complete picture.

Components of a DCF analysis

Now, let's look at the key components involved in a DCF analysis:

1. Projected future cash flows

The foundation of a DCF analysis is estimating a company's future cash flows over several years. This includes:

a. Operating Cash Flow (OCF)

‍Operating Cash Flow (OCF) is a key metric that reveals a company's ability to generate cash from its core business activities. It essentially tells you how much cash the company has left over after covering all its day-to-day operational expenses. These expenses, often referred to as Operating Expenses (OPEX), include salaries, rent, utilities, and office supplies – everything a company needs to keep its doors open and run smoothly.

By analyzing OCF, you gain insights into a company's core profitability. A positive OCF indicates the business is generating enough cash to cover its operational costs and potentially invest in future growth. A negative OCF, on the other hand, might raise concerns about the company's ability to sustain itself in the long run.

‍b. Free Cash Flow to Equity (FCFE)

Free Cash Flow to Equity (FCFE) takes Operating Cash Flow (OCF) a step further to understand how much cash is ultimately available to shareholders. OCF reflects the company's cash generation from its core operations. However, a healthy business also needs to invest in its future by acquiring or upgrading physical assets like buildings, equipment, or technology. These investments are called Capital Expenditures (CAPEX).

FCFE essentially subtracts CAPEX from OCF. This gives you a clearer picture of the cash remaining after the company covers both operational expenses and necessary investments in its long-term assets. This remaining cash is what the company can potentially use for dividends, stock buybacks, or other purposes that directly benefit shareholders. Therefore, FCFE is a crucial metric for understanding the company's ability to provide returns to its shareholders.

A reliable cash flow projection requires a deep understanding of the company’s historical financial data, industry trends that can influence the company's cash generation capabilities and potential risks.

2. Discount rate

Money has a time value. A dollar today is worth more than a dollar tomorrow because you can invest it and earn a return. The discount rate reflects this concept by considering the minimum return an investor expects to compensate for the risk of investing in a particular company.

The discount rate you choose significantly impacts a company's valuation. A commonly used method for choosing a discount rate is the Weighted Average Cost of Capital (WACC).

WACC represents a company's cost of capital, accounting for both equity and debt. It is calculated by taking the weighted average of the cost of equity (the return required by equity investors) and the cost of debt (the effective interest rate paid by the company on its debt), adjusted for the proportion of equity and debt in the company's capital structure. 

Example:

Imagine a company, has the following capital structure:

• Market value of equity (E): $800 million
• Market value of debt (D): $200 million

Total capital (V): E + D = $800 million + $200 million = $1 billion

Read more about capital structures.

Weight of equity (We): We = E / V = $800 million / $1 billion = 0.8 (or 80%) Weight of debt (Wd): Wd = D / V = $200 million / $1 billion = 0.2 (or 20%)

Next, we need to determine the cost of each capital source:

• Cost of equity (Re): Let's assume cost of equity is 12% (this could be derived from various methods like the Capital Asset Pricing Model (CAPM)).
• Cost of debt (Rd): Let's assume the company’s current debt has an interest rate of 8%.

Now we can calculate the WACC using the formula:

WACC = (We * Re) + (Wd * Rd * (1 - Tax rate))

Tax rate: We'll assume a corporate tax rate of 30% (this can vary depending on the location and industry). We typically adjust the cost of debt in WACC by multiplying it by (1 - tax rate). This effectively reduces the cost of debt to reflect the tax savings.

So, the WACC calculation for this company would be:

WACC = (0.8 * 12%) + (0.2 * 8% * (1 - 0.30))
WACC = 9.6% + 1.12%
WACC = 10.72%

The Weighted Average Cost of Capital (WACC) for this company is 10.72%. This means that for every dollar the company raises, it needs to generate a return of at least 10.72% to satisfy its investors and creditors.

3. Terminal value

Since a DCF analysis typically projects cash flows for a finite period (often 5-10 years), a terminal value needs to be estimated. This represents the company's value beyond the explicit forecast period. 

There are two common approaches to do this:

a. Perpetuity growth model (Gordon growth model)

This model assumes that the company's cash flows will grow at a constant rate forever after the forecast period.

Example: If the company’s final projected cash flow is $1 million and we assume a perpetual growth rate of 3%, the formula is:

Terminal value =Final projected cash flow × (1+growth rate)/ discount rate −growth rate

So, if the discount rate is 8%, the terminal value would be:

Terminal Value =1,000,000 × (1+ 0.03)/ 0.08 −0.03

=1,030,000/0.05

=$20,600,000

b. Exit multiple method

This method estimates the company’s value at the end of the forecast period based on a multiple of a financial metric, such as earnings or revenue, then discounts it back to present value.

Example: If the company’s earnings at the end of the forecast period are $2 million and similar companies trade at a 10x earnings multiple, the terminal value is:

Terminal value = earnings × multiple

So, the terminal value would be:

Terminal value = 2,000,000 × 10 = $20,000,000

Estimating a company’s worth beyond a set period gives you some idea of its long-term potential to arrive at a comprehensive valuation.

Once you have your projected cash flows, discount rate, and terminal value, you can use a financial calculator or spreadsheet to discount each year's cash flow back to its present value. The sum of these present values, along with the present value of the terminal value, provides the final DCF valuation of the company.

How to do DCF valuation

Imagine you're analyzing a company that develops eco-friendly tech products. You want to estimate its current fair value using DCF.

Steps for DCF valuation

1. Project free cash flows

This process involves forecasting a company's cash flow generation for a specific period, typically the next 5 years. It's a crucial step in company valuation, particularly when using the Discounted Cash Flow (DCF) method.

The steps involved:

a. Revenue forecast

You'll need to estimate the company's future sales growth based on historical trends, market analysis, and the company's future plans.

‍b. Expense forecast

Estimate the company's operating expenses, considering factors like cost of goods sold, selling, general & administrative expenses (SG&A), and research & development (R&D).

‍c. Capital expenditure (Capex) forecast

Project the amount of money the company will need to invest in property, plant, and equipment (PP&E) to maintain or grow its operations.

d. Calculating Free Cash Flow (FCF) and Free Cash Flow to Equity (FCFE)

Once you have your revenue, expense, and Capex forecasts, you can calculate two key metrics:

Free Cash Flow to the Firm (FCF): This represents the cash available to all the company's capital providers (debt holders, preferred stockholders, common stockholders, etc.).It considers the company's actual debt structure.

Formula:

FCF = Operating Cash Flow (EBIT * (1 - Tax Rate)) - Capex + Changes in Working Capital

Free Cash Flow to Equity (FCFE): This represents the cash flow available specifically to the company's equity holders (common and preferred stockholders). It treats the company as if it were debt-free.

Formula:

FCFE = FCF - Interest Expense * (1 - Tax Rate) + Net Borrowing

Imagine the company's cash flow as a pie.

FCF: This would be the entire pie, representing the total cash flow available after accounting for expenses and reinvestments.

FCFE: This would be a slice of the pie remaining after debt obligations (interest payments) are taken care of.

Projecting FCFs is essential for understanding a company's future cash generation potential. By considering both FCF and FCFE, you gain a more comprehensive picture of the company's financial health and value proposition for different stakeholders.

2. Choose a discount rate

‍Determine the Weighted Average Cost of Capital (WACC) which reflects the risk associated with the company. The WACC considers the cost of debt and equity financing.

‍3. Discount the cash flows

‍Apply the WACC to each year's projected FCF to find their present value. Remember, money today is worth more than money in the future (time value of money).

‍4. Sum the discounted cash flows‍

Add the present values of all the FCFs to arrive at the company's present value.

Calculation

Year 1 FCF: $1 Million

Year 2 FCF: $2 Million

Year 3 FCF: $3 Million

Year 4 FCF: $4 Million

Year 5 FCF: $5 Million

‍WACC: 10%

Discounting the cash flows

• Year 1 Present value: $1 Million / (1 + 0.10) = $0.91 Million
• Year 2 Present value: $2 Million / (1 + 0.10)^2 = $1.66 Million
• Year 3 Present value: $3 Million / (1 + 0.10)^3 = $2.15 Million
• Year 4 Present value: $4 Million / (1 + 0.10)^4 = $2.72 Million
• Year 5 Present value: $5 Million / (1 + 0.10)^5 = $3.35 Million

Company's present value

Sum of discounted cash flows = $0.91 Million + $1.66 Million + $2.15 Million + $2.72 Million + $3.35 Million = $10.79 Million

Based on the projected cash flows and a 10% discount rate, the company’s estimated fair value would be around $10.79 million.

Remember, DCF is a valuable tool for startups and investors alike, but it's crucial to consider its limitations and use it alongside other valuation methods for a more comprehensive picture.