The DCF methods represent the most renowned approach to company valuation, recommended by academics and a daily tool for financial analysts. They are based on the principle that a company is worth the cash flows it is going to generate in the future, once discounted by risk.
Standard application and parameters
Valuation is defined as the present value of all the cash flows a company will generate in the future. To compute this value, future free cash flows to equity must be discounted to present by a discount rate representing the risk of investing in the specific company.
Because of the uncertainty of the future, projections beyond 3 to 5 years become less and less meaningful, so techniques are applied to capture the value of all cash flows after the last projected year – the terminal value of the startup. The are 2 techniques to determine the terminal value, therefore 2 DCF methods:
- For the DCF with LTG (Long term growth), the terminal value is computed with the assumption that the company is going to survive and grow at a steady and constant rate
- The DCF with multiple uses as a proxy of the terminal value the potential exit value computed through a multiple.
Regardless the methods, all the elements are combined according to this formula:
Where Y1, Y2, Yn are the cash flows in the first, second, and n-th year; DR is the discount rate; TV is the terminal value.
Adjustments for young, fast growing companies
Following the guidelines supported by Prof. Aswath Damodaran of New York University, a number of adjustments is applied to reflect the additional risks of a young, fast-growing company:
- Country-level survival rates are used to take into account the probability that the company will go bankrupt, failing before delivering the projected result
- An illiquidity discount is applied to take into account the risk of being unable to resell the stocks of the company due to the lack of a market for them
The formula eventually applied is:
Where SR is the survival rates of the corresponding year; ID is the illiquidity discount.
Startups’ financial projections for the DCF
Financial projections – necessary to estimate the cash flows – are a fundamental component of these methods. This draws criticism by investors on the usage of this method for startups, as performance forecast in startups is highly affected by uncertainty. However, this is also the best way entrepreneurs can incorporate their unique roadmap to growth and cash generation in the valuations – a recommended element for computing the fair valuation from the company’s perspective.
Equidam’s DCF methods are designed and weighted to be taken into account together with the other methods by companies at any stage, making their valuation more informative and reliable.