Discounted Cash Flow Analysis Made Simple
At Peak Business Valuation, business appraiser Utah, we often rely on a mixture of historical and present earnings to appraise a business. The value of a business ties to the earnings it generates. This method is known as the capitalization of earnings method. It relies on the present and historical earnings of the company. However, there are some business models that don’t align with this method. Tech startups are an example of this. In the early stages of a tech startup, companies are not generating cash, they are burning cash. If we were to rely on the present earnings of the company, the value would be less than $0. In cases like this, it is appropriate to perform a discounted cash flow analysis to determine the value of the business.
A discounted cash flow analysis looks at the cash flow the company expects to produce to value the company. A valuation expert then discounts the cash flows. The time value of money is the primary reason to discount the cash flows. Money in your hand today is worth more than money tomorrow. Thus, the cash flows in the future are not worth their full dollar value. As such, a valuation expert discounts them. In this article, we will provide a simple overview of how to value a business, such as a tech startup, using a discounted cash flow analysis.
The Life of an Early-Stage Enterprise
Another name for a tech startup in its pre-profitability stage is an early-stage enterprise. An early-stage enterprise can be broken up into four stages of financing. For a discounted cash flow analysis, we begin our analysis in the traction phase and project forward into the developed phase.
1. Seed and Start-up Financing
A company goes through several stages before it becomes profitable. An early-stage enterprise begins by getting start-up financing. At this stage, the product is often more of an idea than an actual product. Funding often comes from friends, family, and angel investors.
2. Later Rounds of Funding
Investors validate the earnings potential of the product by continuing to invest in later rounds of funding. Obviously, an investor would not continue to invest if they didn’t expect a return!
3. Traction Phase
The traction phase is where the magic happens. The company still is not profitable, but its revenue is growing. Tech companies today can be valued at billions of dollars while in the traction phase. The traction phase is the most appropriate time to perform a discounted cash flow analysis.
4. Developed Stage — Post profitability
Finally, the business moves into profitability. Growth stabilizes and the business becomes profitable.
Discounted Cash Flow Analysis
There are three main components of a discounted cash flow analysis. They are free cash flow, discount rate, and terminal value.
– Free Cash Flow
An analyst projects free cash flow, or earnings, into the future, usually 5-10 years. The company selects a period based on when it believes its growth rate will stabilize.
– Discount Rate
Once cash flow has been projected for each year, each value needs to be discounted at the discount rate. The discount rate represents the risk of the cash flows. It includes general economic factors, industry factors, and risks specific to the company. Risks specific to the company include the cost of debt, equity, and the probability of failure.
– Terminal Value
Now that all the cash flows have been projected and discounted, we need to include terminal value in our analysis. Terminal value is the value of the business assuming its growth rate will be stable into the future. The Gordon growth model is a common approach to calculating the terminal value. The formula looks like this:
Gordon Growth Model:
Final year cash flow * (1 + Stable growth rate) / (Discount rate – Stable growth rate) = Terminal value
In practice it may look like this:
$100,000 * (1 + 3.00%) / (10.00% – 3.00%) = $1.47 million
Arriving at a Business Value
The terminal value is then added to each discounted cash flow to arrive at the value of the business. These are the basic mechanics of how to value a business that may be profitable in the future. As you can see, a discounted cash flow analysis can become complex for a few reasons. Number one, you are relying on assumptions and projections of free cash flow. Second, the risk associated with the company will vary over the period you are projecting. Third, it is difficult to surmise when the company’s growth rate will stabilize. These factors call for a dynamic model that changes with the company. A valuation analyst may also decide to have a discount rate that changes each year in the analysis as the risk of the company decreases. The same approach could apply to growth rates, changes in expenses, and the acquisition of capital.
Determining the appropriate methods to use to value your business can be complex. At Peak Business Valuation, business appraiser Utah, valuation is both an art and a science. We understand that performing a discounted cash flow analysis can be difficult.
Most often a business valuation report includes a combination of valuation methods to determine the fair market value of the business. Other methods include the market approach and the income approach. Each of these methods requires expertise to arrive at a fair value for the business. So don’t leave the value of your business up to chance! We are happy to answer any questions you may have. Give Peak Business Valuation, business appraiser Utah, a call today, or schedule your free consultation below.
Schedule Your Free Consultation Today!