The Discounted Cash Flow Method predicts a startup’s value by discounting all of its predicted cash flows by a discount rate that is meant to compensate for its riskiness. For this, future cash flows need to be predicted with a detailed financial model and an appropriate risk factor needs to be determined. This renders a high degree of precision in calculating a startups valuation, but also introduces a huge amount of variability due to the many assumptions used.
Any investment is worth how much money you can make from it. But what does that actually mean in practice? You need to think of a way to predict cash flows for the future and in theory your company can live forever. Also, even if you come up with all these cash flows, shouldn’t you evaluate an investment based on its riskiness?
The Discounted Cash Flow approach combines all of this:
- First you plan your cash flows,
- then you discount it by a risk factor (= “required rate of return”) and in the end
- you get a value (= “Net Present Value”) for your company
Let’s explain this with an example.
Example: Discounted Cash Flow – Valuation Method
Assumptions
Let’s first walk through the assumptions. So, in general any company requires an initial investment. Here we assume one sinlge investment of $1,500. Of course in reality, investments might occur at multiple points in time over many financing rounds.
Secondly we need to predict our cash inflows from operations. Financial modelling is its own complex topic, which is further explained here (Revenue Models) and here (Cash Flow Models). But its safe to say, that in any startup model, there will be an initial fast growth period, which is planned in detail, followed by a steady growth phase for the later years, which is approximated by a single steady low growth rate.
In this example we simply assume a 100% fast growth phase on an initial cash inflow of $1,000 from year 1 to year 3. This is followed by a steady growth phase in year 4 from which cash flows only grow at 5%. Finally we picked 15% as our discount rate in this example.
Why discounting?
People like to use loans as an example the explain the concept of discounting cash flows. In loan finance, the first cash out flow is the principal loan amount that you are lending someone, e.g. 1,000 dollars. Then you receive interest payments of let’s say 20% per year for the next 5 years and eventually you get your 1,000 dollars back. In absolute terms, you made 1,000 dollars from this investment, but to compare this specific investment to other potential return opportunities you need to always keep the duration and the per period return in mind.
DCF Calculation Explained
All our cash flows then need to be discounted by the required rate of return to get a total value of the company at the end of year 0. For that you divide each cash flow by 1 plus the required rate of return raised to the power of the number of years that have passed since the initial investment. You do that for all the years of the fast growth period, where each cash flow is planned in detail. Note that in your financial model, you wouldn’t simply let the fast growth period be determined by one single growth factor. You would actually have a lot of inputs and cash flows in the early years could bounce around significantly.
Beyond the initial fast growth phase, you don’t actually have to project each single cash flow anymore. You use the Terminal Value concept to project what all future cash flows starting from the year of the steady growth phase will be worth. There are two ways to calculate it: The Gordon Growth Method and the Exit Multiple Method. You can see both methods explained in detail here. In this example we use the Gordon Growth Method, which uses an annuity formula to calculate what the company will be worth at the end of the year that marked the beginning of the fast growth phase.
One thing to note in regards to calculating Terminal Value with the Gordon Growth Method: You have to use the Cash Flow one period AFTER the period for which you calculate the Terminal Value. In the example above we grow the final cash flow of $4,410 by another 5% before using it in the Gordon Growth Formula. So its the Cash Flow of year 6 to be exact. At the same time we discount by 5 years. Very classic mistake!
Result of a DCF
Once all cash flows and the Terminal Value are calculated and discounted, you add them together, deduct the initial investment and you got yourself the total value of the company on investment. In our example the Net Present Value of this company is $30,032. This means, at the beginning of the company’s life, it is predicted to be worth $30k after investment.
Of course very hypothetical, as nobody can guarantee that cash flows play out as predicted and so on. Let’s look at how changing assumptions play a significant role in the outcome of this calculation.
Understanding DCF: Changing Assumptions
Increasing the number of fast growth years – IMPACT: HUGE
As you play with your own financial model assumptions, you will come across two realities:
- Cash Flows of earlier years matter more because they have been discounted by less periods
- The later the steady growth period starts, the higher your NPV will be because your Terminal Value is based solely on the last Cash Flow of the fast growth period.
This has significant implications on how you use the DCF in startups due the massive planning uncertainty. Think of this, most financial models have a time horizon of 3-5 years. Beyond 5 years everybody will raise their eyebrows at your financial model. However, even Facebook took 8 years until IPO and had arguably 15 years of fast growth. Amazon has been on fast growth for almost 25 years! Even app companies or marketplace businesses need a couple years to develop all revenue streams and enter into all markets.
As a consequence, if you extend your model from 3 to 5 years you will significantly increase your company’s NPV. Just copy forward the same formulas of the first three years and let all your assumptions move likewise.
Moving the terminal value calculation year – IMPACT: NONE
In the example above the steady growth phase starts at year 4, and we calculate the Terminal Value for year 3. We could as well project a few more steady growth cash flows and apply the Terminal Value formula a few years later. Simply discount it by more years. This would have NO IMPACT on the Net Present Value. Your company value does not change from that.
Not all cash flows are owned by shareholders
In our simplistic example one thing hasn’t been made clear: Not all returns become cash flows owned by shareholders. Some of it goes to lenders for example. This is why older companies with debts on their balance sheet (or projections) use Unlevered Free Cash Flow for their DCF. For most startups this will likely not apply in the first few years.
Pros and Cons of DCF for Startups
Practitioners tend to smirk at you when the word DCF comes out of your mouth and you are still running an early stage startup. That is because there are so many unknowns nobody can reasonably claim to have “calculated” the right price. The problem with that is, people should still try. Here are some reasons for and against a DCF in the first years of startup:
Reasons FOR using DCF for Startups
- Its a great thought experiment to build an in-dept financial plan from which you will learn a lot
- It will help new founders gradually understand how to drive shareholder value
- Eventually you will get more hard metrics of your business and your DCF will become better – why not start early
- The closer your DCF is to reality (also proven by your recent historicals), the more credible your pitches will be
Reasons AGAINST using DCF for Startups
- The DCF requires you to know all future revenue streams and markets to be correct
- The differentiation between slow and fast growth has a huge impact on the final value
- The shorter the fast growth period, the lower the company value
- The longer the fast growth period, the more unpredictable things get
- Even Facebook took 8 years until IPO and had fast exponential growth for years after that
Summary
The DCF approach, as widely as it used, receives quite a mixed welcome in the Startup community. This is due to the planning uncertainties Startups face and the huge swings every assumption change has on a DCF.
That said, there is something to starting early with detailed financial models and even using the DCF as one more tool to sell your equity at a high valuation. Just make sure you are aware how the assumptions work and apply them in your favor. But don’t start believing you can predict the future in Excel.
Table of Contents