Digging into the DCF Analysis

Valuation is the process of determining the current worth of an asset or a company. An analyst placing a value on a company essentially looks at the business’s management, the composition of its capital structure, the prospect of future earnings, and the market value of its assets.

Start-up valuation is simply the value of a start-up business taking into account the market forces of the industry and sector in which that business belongs.

VALUATION USING DISCOUNTED CASH FLOW METHOD

Diving directly into the nuances of the topic, Discounted cash flow (DCF) as you may know, is a valuation method used to estimate the value of an investment based on its future cash flows. But how, might be the next question that pops in your mind, before we dive into that, let us first understand the concepts linked to it. DCF analysis finds the present value of expected future cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered.

Free cash flow for the firm (FCFF) represents the amount of cash flow from operations available for distribution after depreciation expenses, taxes, working capital, and investments are paid. FCFF is essentially a measurement of a company’s profitability after all expenses and reinvestments. It’s one of the many benchmarks used to compare and analyse financial health.

FCFF = net income + non-cash charges (e.g. – depreciation) + interest x (1 – tax rate) – long-term investments – investments in working capital

For business valuation purposes, the discount rate is typically a firm’s Weighted Average Cost of Capital (WACC). Investors use WACC because it represents the required rate of return that investors expect from investing in the company.

Weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted.

All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation. A firm’s WACC increases as the beta and rate of return on equity increase, because an increase in WACC denotes a decrease in valuation and an increase in risk.

To calculate WACC, multiply the cost of each capital component by its proportional weight and take the sum of the results. The method for calculating WACC can be expressed in the following formula:

WACC= E/V * Re + D/V * Rd * (1-Tc)

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = Corporate Tax rate

Net present value (NPV) is the summation of the present (now) value of a series of present and future cash flows. It is calculated as the summation of the free cash flows to a firm discounted by the WACC (discount rate) for a particular number of years.

NPV = FCFF1/(1+WACC)^1 + FCFF2/(1+WACC)^2 +…+ FCFFn/(1+WACC)^n

where n is no. of years for which NPV is calculated or the cash flows are forecasted.

Discounting is necessary because the time value of money creates a discrepancy between the current and future values of a given sum of money. In business valuation, free cash flow or dividends can be forecast for a discrete period of time, but the performance of ongoing concerns become more challenging to estimate as the projections stretch further into the future. Moreover, it is difficult to determine the precise time when a company may cease operations.

To overcome these limitations, investors can assume that cash flows will grow at a stable rate forever, starting at some point in the future. This represents the terminal value (TV), and it is calculated by dividing the last cash flow forecast by the difference of the discount rate and the stable growth rate.

TV  =  (FCFFn x (1 + g))  /  (WACC – g) where g is the perpetual growth rate calculated to determine the present value of cash flows beyond the forecast period.

In case of start-ups, TV is calculated using the exit multiple approach whichassumes the business is sold for a multiple of some metric (i.e. EBITDA) based on currently observed comparable trading multiples for similar businesses.  The formula for calculating the terminal value is:

TV  =  Financial metric (i.e. EBITDA)  x  trading multiple (i.e. 10x)

Hence, the estimated value of the company is the sum total of the net present value and the terminal value calculated.

Value = NPV + TV