Startup valuation using Discounted Cash Flows (DCF) method

In this article, ThinkZone will introduce to you how to value businesses, especially startups, using the Discounted cash flow (DCF).

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WHAT IS DISCOUNTED CASH FLOWS?

This is a method of valuing a business by predicting the future cash flows of that business and then discounting them to the present time, with the assumption that the value of the business is equal to the total present value of the cash flows that the business is expected to generate in the future.

Formula for business valuation according to DCF method:

 

In there:

➤  CF: The company's expected cash flow in years 1, 2,..., n.

➤  r: Discount rate.

➤  DCF (Discounted Cash Flows): Discounted cash flows, representing the Value of the business.

Why is discount necessary?

One of the basic principles of finance is that “currency today is worth more than the same currency in the future”. This principle is related to a concept that is “time value of money”.

The reason why money in the future is less valuable than it is today is because people tend to want money more immediately, as well as the risks that may arise in the future. Discounting to the present value ensures a true reflection of the actual value of the cash flow, after considering risk factors. (inflation, crisis,...) to have the most reasonable valuation.

Therefore, in the above formula we have terms CF/(1+r)^n, in there discount rate r represents the risk that investors expect for the future. The larger this ratio, the smaller the CF/(1+r)^n, i.e. the smaller the present value of the cash flows in year n, resulting in a smaller valuation of the company.

WHY USE DCF? WHAT ARE DCF'S WEAKNESSES?

The DCF method provides a more multi-dimensional perspective when founders and investors value a company. Normally, investors often use many different valuation methods, each method applying a different perspective.

Specifically, the DCF method values ​​a business based on expectations about that business's capacity in the future. This is different from the method asset valuation (based on what the founder has spent since the time of establishing the business, that is, looking back into the past), and comparison method (with similar companies in the market, that is, looking at the present).

After valuing using many different methods, investors will most likely obtain different numbers. These numbers help them determine what range the business valuation falls within. And the remaining work is the negotiation between the founder and investors to come up with the final number.

➤ You can read more about other valuation methods in the article: 5 commonly used business valuation methods.

Advantages of DCF

The DCF method values ​​a business based on its financial capacity in the future, so businesses that have historical cash flow data will help predict future cash flows more accurately. And because the DCF valuation formula is built strictly on corporate finance, the resulting numbers will be more grounded and easier to convince both startups and investors. 

Weaknesses of DCF

Because valuation is based on a business's expectations about future business performance, this method inevitably comes with the risk of predicting the future. From the formula above, you can see: we need to predict two things, discount rate r (represents the level of future risk), and CF cash flow that the company hopes to create.

Forecasting cash flow is difficult due to a number of factors:

➤ Startups in the early stage that have only been established for 1-2 years do not have much past data as a basis for predicting future cash flow;

➤ Many Vietnamese startups do not prepare financial reports properly, leading to a lack of data for prediction;

➤ Unlike traditional businesses with fairly steady growth graphs (for example, 5% growth every year), startups' growth graphs are often very sudden and difficult to predict (for example, the first 2 years grow at 0% and -5%, the third year can suddenly grow up to 20%).

Predicting r is not easy, because no one can accurately predict data such as inflation rate, financial crisis, or even Covid.

* In short, each valuation method has its own advantages and disadvantages, so investors often combine many different methods to come up with the most reasonable number. And the final number, of course, is a matter of negotiation between founders and investors.

HOW TO APPLY DCF TO BUSINESS VALUATION?

Let's look again at the business valuation formula according to DCF:

Step 1: Make a financial estimate for the company

As mentioned above, you need to predict the company's financial capacity in the coming years, and this financial capacity is reflected in the company's cash flow. (see step 2). Usually companies often forecast for 5 years (sometimes 10 years) next.

In financial forecasting, you will need to forecast revenue, expenses and investments for the coming years, expressed through P&L (profit & loss) reports, Balance sheets, and Cash Flow reports, as well as key company KPIs (on which forecasts are based).

Step 2: Determine “Free Cash Flows”

Below is an example of DCF valuation. Business valuation (Enterprise Value) To be 269 ​​million USD in 2017.

Unit: million USD. Source: EY.

In the above example, Free cash flow (Free Cash Flows) Identified in the yellow box, these are numbers that represent the company's financial capacity. Free cash flow is defined as the cash flow needed to keep the company operating in the short term, specifically the amount of cash remaining in the company after all short-term expenses have been deducted.

Free cash flow is calculated as follows:

Step	Explain	Source of information
1: Start with EBIT	EBIT (Earnings before Interests and Taxes) is a business's profit before taxes and interest.	P&L report
2: Minus operational taxes	This is a tax levied directly on the company's financial results.	P&L report
3: Adjust according to investments (Investment)	These are investments in factories and machinery. If you buy machinery and build a factory, this number will be subtracted from Free Cash Flows, and added back if you sell the machinery/factory.	Cash Flow Statement or Balance Sheet
4: Add up Depreciation (Depreciation)	Depreciation is counted as an expense when calculating EBIT in the P&L statement. However, depreciation is not a true cash flow (because no money actually leaves the company), so it needs to be added back into Free Cash Flows.	P&L Report or Balance Sheet
5: Adjust investment in Working capital (Working capital)	Calculated based on Short-term Assets and Liabilities. Working capital = Short-term assets - Short-term liabilities	Balance Sheet

After the above calculation steps, you have determined the CFs in the formula. The remaining problem is determination discount rate r. 

Step 3: Calculate the discount factors (Discount factor) 

Discount factor is the term 1/(1+r)^n in the formula, shows how much of the value of the future CF will be left at the present time. And our problem is to determine r. 

People enjoy using it WACC (Weighted Average Cost of Capital – Average cost of use and capital) for r. Basically, WACC represents the future risk of cash flows, the higher the WACC corresponds to the greater the risk, leading to a smaller Discount Factor, and a smaller business valuation. However, to understand WACC and how to determine it, we will need another in-depth article, so ThinkZone will not go into WACC in this article. 

Unit: million USD. Source: EY.

As the example above, we can see, with r = WACC = 15%, 93 million USD in 2021 is just worth it 46 million USD in 2017, respectively discount factor 0.5. 

With the variables defined, we have the sum Free cash flow of the years 2017 - 2021 (after discount to 2017) To be 61 + 56 + 53 + 53 + 46 = 269 (million USD). 

* However, the work does not stop here, because you have only predicted the cash flow of the next 5 years. And obviously no company plans to close after 5 years. Therefore, we will need one more step to calculate the Free Fairy Flow of the following years. 

Step 4: Calculate Terminal Value

Terminal Value is the value that represents the company's Free Cash Flows for the years after 2021. Essentially, it is the limit of the sum of terms CF/(1+r)^n when n runs to positive infinity (for n > 5). 

Photo source: Internet.

To calculate this limit, we will assume CF growth rate after each year is g. Then Terminal Value will have the value: 

Terminal Value This will be discounted to its present value (2017) with the same Discount factor for year 5. So, let's say g = 2%, we have Terminal Value ~ 730 (million USD), after discounting to 2017 with discount factor 0.5, I can 365 (million USD). 

 

Unit: million USD. Source: EY.

Step 5: Add the discounted cash flows together 

With the discounted cash flows, we just need to add them together to get the startup's valuation according to the DCF method. Specifically, the valuation in this example is:

61 + 56 + 53 + 53 + 46 + 365 = 634 (million USD). 

SUMMARY 

So we have gone through an overview and instructions for using the DCF method in business valuation. As mentioned above, with the characteristics of predicting the future, this method often comes with a lot of arguments between founders and investors about how to predict r and CF.  

Therefore, to have the most overview of the future, investors when valuing using DCF often outline many different scenarios, usually the worst scenario, normal scenario, and best scenario. Each scenario will result in a different valuation number, giving them an idea of ​​where the company's true value lies.