Projections and cash flows are important aspects of a startup valuation. But how do you convert all these parameters to calculate the value of the company today?
One of the major methods used today is called Discounted Cash Flow (DCF).
What Is DCF?
Discounted cash flow is a methodology of future cash-flow actualization. It transforms future cash-flows in their equivalent value today.
The main underlying assumption of this methodology is that money tomorrow is worth less than money today. This is driven by risk and inflation. One dollar today is more valuable because it is certain, or more certain, compared to a dollar tomorrow.
By understanding the risk of earning that money in the future, we can discount future cash-flows and understand their value today. Of course, the riskier the future cash flow, the higher the discount rate that needs to be applied.
“Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you’d receive from an investment and to adjust for the time value of money.” (Investopedia)
DCF valuation is widespread in public markets to understand the price of publicly traded companies, but can it be applied to early stage, high growth, high risk ventures?
DCF Model and Startups
Remember: “In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it’s going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as “discounted” cash flow because cash in the future is worth less than cash today.” (Investopedia)
As every valuation method based on the future, DCF values are dependent on the accuracy of forecasts. For early stage companies, with zero or no track record, and being likely to fail, these forecasts are usually far from accurate.