Many investors rely on the discounted cash flow (DCF) method to estimate the value of startups and early-stage companies. DCF analysis determines a company’s fair value based on projections of its future cash flows. Here’s an overview of how it works and why it can be useful for startup valuations.
The DCF methodology is based on the present value of expected future cash flows. Specifically:
- Project the startup’s unlevered free cash flows (UFCF) for the next 5-10 years. This requires making assumptions about future revenue growth, operating costs, capital expenditures, etc.
- Calculate the terminal value after the discrete projection period, representing the startup’s value in perpetuity. The terminal value is often calculated using a perpetuity growth formula like Gordon Growth Model.
- Discount each year of projected UFCFs and the terminal value by the startup’s weighted average cost of capital (WACC) to get their present values.
- Sum the present values of the discrete projected UFCFs and terminal value. This is the net present value (NPV) – an estimate of the startup’s fair value today.
Advantages of DCF Valuation
When done right, DCF valuation has several advantages for startups:
- Cash flow-based: DCF looks at cash generation ability, which is ultimately what determines startup value. Earnings or revenue-based multiples can be misleading.
- Flexibility: DCF allows factoring in complex assumptions like varying growth rates, investment needs, and margin projections over time.
- Long-term outlook: DCF considers long-term cash flow potential rather than focusing only on the next few years.
- Ideal for predictable cash flows: DCF works well for startups with reasonably predictable cash flows from long-term contracts or subscriptions.
valuation startup methods
The DCF method offers a rigorous way to value startups based on business fundamentals. However, the quality of the valuation depends heavily on the reasonability of cash flow projections. Startups with limited operating history require more assumptions and subjectivity in DCF models.
