The peak of entrepreneurship has given birth to one of the most widely used terms in the history of business and finance – startups. A startup is basically a seed that wants to grow and mature.
Startups, pretty much like seeds, need money to grow themselves and fully develop their underlying idea or concept. To raise money a startup needs to be valued, and therefore understanding how the startup valuation methods work becomes essential for entrepreneurs.
The most common question entrepreneurs ask themselves when looking for external funding is what is the valuation of my firm? And how to define the valuation of a startup that maybe is standing without any assets and revenue?
Fortunately, Venture Capital firms and individual investors have dozens of valuation approaches, ranging from the easiest ones to the most intricate ones that involve several qualitative variables and statistical analysis. And while there are many ways to value a startup, the discounted cash flow method is the most versatile technique in the world of valuation.
What Is The Discounted Cash Flow Method?
Discounted cash flow method is a valuation process that calculates the value of a company based on its business performance. DCF model also known as the intrinsic value approach, is the most commonly used to assess startups and mature businesses.
The DCF valuation method is mainly based on future performance and the value of future earnings is worth less today than in the future.
For example – You can put Rs. 5000 you got today in a savings account where you will receive a 5% interest rate which means it can increase to 5250 in one year. Rs. 5000 will be worth more a year later owing to the interest accrual and inflation.
If a person is seeking to invest 5000 now, he or she will want to know its return on investment and what its future valuation will be, and this valuation will be calculated through the discounted cash flow method.
What Is The Advantage Of The DCF-Method For Your Startup?
The discounted cash flow valuation method provides some significant advantages, giving the startups a unique insight into the value of their firms and the state of their wealth management.
Apart from that the main advantage of the method is that it values a firm based on future performance. That is perfect for a startup that might not have realized any historical performance yet.
It is common for startups in their pre-seed stage to not generate revenue at all whilst discussions regarding equity transfers, ownership percentages, and the accompanying valuation already arise.
Since many business owners have a substantial portion of their wealth linked up in the firm, an independent DCF analysis will make it easier to define their asset allocation.
How Discounted Cash Flow Valuation Works?
Discounted cash flow valuation can get pretty complicated, but acquiring a basic knowledge of the method is relatively easy. In its simplest terms, the discounted cash flow (DCF) method aims to specify the current value of a firm, based on predictions of how much the firm stands to make in the future.
Some of the factors that are considered include; AUM – Assets Under Management, business continuity plans, non-compete agreements with key employees, average client age, a mix of revenue sources, relationship with the next generation, and future projected growth rates. These aspects will influence the attractiveness and value a potential buyer is ready to pay. Having a precise sense of the gaps today will allow you to know what you require to do to improve and maximize the value in the future.
How To Apply The Discounted Cash Flow Method?
After we have cleared the theory behind the DCF-method, below you can see what the DCF is: a formula. In the above paragraph, we explained to you in a common language how a DCF works, now we will know how to apply the DCF formula in five easy steps.
DCF = CF1/(1+r)1 + CF2/(1+r)2+…+ CFn/(1+r)n
CF= Cash Flow
r = discount rate
Five steps to take when calculating a company’s value through a DCF model:
Step 1: Creating Financial Projections
The very first step towards valuing a business with a DCF model is forecasting the company’s future financial performance. The calculation of the free cash flows is not complicated, but you need a couple of ingredients to be able to perform the calculation.
You will need all three financial statements that are the income statement, cash flow, and balance sheet. As from the three financial statements specific information will be taken out.
Step 2: Building Free Cash Flow
The second step employs the financial forecasts information to calculate the Free Cash Flow (FCF).
FCF = EBIT – Tax Expenses + Depreciation & Amortization – Changes in Working Capital – Capital Expenditure.
|Steps||Explanation||Where can I find this information?|
|EBIT||Earnings before income and taxes from the financial projection.||Profit & loss statement|
|Tax Expenses||The annual tax expenses the company will pay.||Income Statement|
|Depreciation & Amortization||Company’s yearly amount that will depreciate for a fixed asset, tangible and intangible assets.||Profit & loss statement and/or the balance sheet|
|Changes in Working Capital||Difference between the current assets and the current liabilities. That includes cash and accounts receivable or inventory and accounts payable.||Cash flow statement|
|Capital Expenditure||The amount of money a business spends to buy or improve its fixed assets.||Statement of cash flows and/or the balance sheet|
Step 3: Determine The Discount Factor
Since receiving Rs. 100 today does not equal receiving Rs.100 in 2 years it needs to reflect in the model.
So how to determine today’s value of the future cash flows? Well,the discount rate does it by adding the time value of money to the model. Calculated is based on the WACC, the Weighted Average Cost of Capital.
This formula calculates WACC:
WACC = (E/(E+D))*Re + (B/(E+D)*Rd * (1-T)
E = Market value of the company’s equity.
D = Market value of the company’s debt.
Re = Cost of equity or required rate of return.
Rd = Cost of debt. This is the debt’s interest rate or yield to maturity on existing debt.
T = Tax rate
Step 4: The Terminal Value
The terminal value is calculated to illustrate the forecasted cash flows that the business will generate. There are many models and methods to estimate the company’s terminal value. The most preferable one is the stable growth model for simplicity.
The formula calculates terminal value: Terminal Value = Cash flow * (1 + future growth rate)/(WACC – Growth rate).
Step 5: Building The DCF Model.
Finally, the tough work is over! One last sum and your startup valuation are finished.
Now each year will be discounted to the present using the discount rate we calculated above according to the PV calculation below.
Total present values
= Σ Cash Flow in year one/ (1+ WACC)1 + Terminal Value/ (1+ WACC)1
Nevertheless, the steps and details presented in this blog can give you a clear idea of what you could expect and what you should be asking for from potential investors based on your startup’s valuation.
My Valuation is a full-service business valuation and advisory firm based in Bangalore and Ahmedabad. Our goal is to aid businesses in figuring out the complexities of valuation and helping them assess their business.
Please visit our site to learn more about how our valuation services can add value to your business: https://myvaluation.in/