So far the theory behind the DCF-method. Below you can see what the DCF really is: a formula. Please don’t freak out when looking at it, as we are going to walk you through it step by step. In fact, in the previous section you have already read in common language how it works: the formula represents the value of all future earnings (the free cash flows), corrected for their worth today (the present value of the net cash flows). These are summed up to a total value.
Step 1: Create financial projections for your firm
In order to perform a valuation for your startup using the DCF-method you will need to forecast your future financial performance. In the DCF-method you present this performance as the future free cash flows (see step 2). This is usually done for the next five (or sometimes ten) years.
The calculation of the free cash flows is not complicated, but you need a couple of ingredients in order to be able to perform the calculation. If you want to perform a DCF-valuation you will need to create a financial plan/model in order to come with all the required elements.
In a financial model you project your revenue streams, costs, expenses and investments for the years ahead. These come together in a financial overview in which you present a prognosis of your financial statements (profit & loss, balance sheet, cash flow statement) and the predominant main Key Performance Indicators (KPIs) for your firm.
A financial advisor can help you with creating your financial model. However, if you feel confident doing this yourself it is good to know that there are many online Microsoft Excel templates available which you can modify and that there are also online tools (such as EY Finance Navigator) which can help you with this. If you want a deep-dive into financial modeling, you can check out our ultimate guide to financial modeling for startups.
Step 2: Determine the future “free cash flows”
Below you will find an example of a valuation according to the DCF-method. The valuation (within the red borders) of this fictional example was made on January 1st 2017 on the basis of a five year prognosis.
In the above overview you will find the calculation of the “free cash flows” within the yellow borders. The free cash flows can be seen as the future financial achievements of your firm, which are used in order to determine the value of your startup today.
The DCF-method uses the free cash flows as these are corrected for the investments that are required to keep the firm running in the short term. This means that the free cash flows represent the cash that is readily available after all potential short term liabilities have been fulfilled: thus a good measurement for the performance of a firm.
As you can see in the yellow part of the above overview, the free cash flows are calculated as follows:
Et Voilà! The most time consuming step in the process of valuing your startup by using the DCF-method has been performed: the calculation of free cash flows. Now you know the future earnings that are the basis for your valuation.
As you may have noticed, you can find the ingredients required for such a calculation in various parts of your financial statements (profit & loss statement, balance sheet and statement of cash flows). That is why a completefinancial modelis crucial when applying the DCF-method for valuing your startup.
Step 3: Determine the discount factor
As explained earlier in the example where I said I will give you €1,000 (disclaimer: I am not planning to honor that promise ;) ), the value of money deteriorates over time: future money is worth less today. So how do you determine today’s value of the future cash flows that we have calculated in step two?
You do this with the help of the discount factor (see the blue lined part in the valuation example above), which you calculate based on the WACC, the Weighted Average Cost of Capital. The calculation of the WACC might be even more difficult than remembering what the abbreviation stands for. That is why won’t do a deep-dive into the WACC right now.
In essence the WACC is a percentage and is (in the context of valuating a startup) a way to define the risk an investor is taking when he/she invests in a firm. The higher the WACC percentage, the higher the risk and the lower the valuation of your firm. As investing in startups is risky to begin with, it is not strange to see high WACC percentages for such firms.
So, what do you need the WACC for anyway? With the WACC you calculate the discount factor. The discount factor determines the present value of your future cash flows, in other words: your valuation! The discount factor is calculated using the formula below, per year:
Discount factor = 1 / (1 + WACC %) ^ number of time period
The number of the time period is in this case the specific year of your forecast. In our valuation example above 2017 is time period number one, 2018 is number two, and so on. In the blue-bordered section you will see that when the WACC is 15% (using the formula above), the discount factor is 0.87 in 2017 and 0.50 in 2021.
Observe how the discount factor decreases over time. This clearly shows the essence of the decrease in monetary value over time. The further away your future earnings are generated, the less they are worth today.
Moreover, given the discount factor formula above, the higher the WACC %, the lower the discount factor, which in turn means a lower monetary value of the cash flows. This illustrates how a higher risk of investing (a higher WACC) also reduces the value of the cash flows and thereby the valuation.
Add up the present values for all five years of the forecast (61 + 56 + 53 + 53 + 46 = 269) and you have the valuation for the period 2017 – 2021 (marked with the red lines in our example). Easy peasy lemon squeezy, right…?
Unfortunately you’re not done yet! This valuation is based only on the value that your startup creates in the period from 2017 to 2021. But what about the years thereafter? You are not planning on terminating your thriving business by 2021, are you? Of course you’re not!
Besides calculating the net present value in the period 2017 – 2021, you also need to calculate the value for the cash flows generated in the years thereafter; that is, all the years after 2021. This is called the “terminal value”. In the example below you can see (in the orange marked fields) which elements of your valuation are affected by this terminal value.
The calculation of this terminal value is in fact rather easy if you have gone through steps one to three already. First, you calculate the earnings that you expect after 2021 (the free cash flows). You can do this by taking the cash flows of 2021 and multiplying them with a growth rate. For this purpose you can use the following formula:
Free cash flows after 2021 = Free cash flow for the last projected period (in this case 2021) * (1 + growth factor).
If you want to use a conservative approach, you use the inflation percentage as growth percentage. However, if you are feeling optimistic you could also use the projected yearly growth rate of the free cash flows of your firm. After making your decision you can calculate the terminal value (in the yellow borders in the above example) as follows:
Terminal value = Free cash flows after 2021 / (WACC – growth rate)
Thereafter the terminal value for the period after 2021 is discounted in the same manner as the cash flows for the period 2017 – 2021. So the terminal value is multiplied with the discount factor. Since you are assuming that the terminal value is calculated as of the last year of your prognosis (in this case five years and hence 2021), you use the discount factor of year five; in our example 0.50 (as shown in the red bordered section above). This is used to calculate the net present value of your terminal value (indicated in the green lined section in the above example).
Step 5: Aggregating all your calculations’ results
The hard work is over! One last sum and your startup valuation is finished. In step four you have calculated the net present value of all future cash flows (including the Terminal Value). When you add all these values (as done in the green section below) you arrive at the value of your startup on the basis of the DCF-method (orange bordered in the overview below).
Step 6: (for the pro’s): create different scenarios and analyses
Finished, right? Well, not quite.. For the pro’s there is another step to take. As the DCF method is a formula and therefore very sensitive to the input variables, it is a good idea to create different scenarios and analyses. In doing so you gain a better understanding of the possible valuation results when you are tweaking your forecast and the input variables of the formula.
As the valuation is based on the free cash flows and these cash flows result from the forecasted performance of your startup, it is smart to create multiple version (“scenarios”) of your forecast. It is common practice to create a worst case, base case and best case scenario.
This provides you with insights in the performance of your firm when things do not go as expected, for better or worse. This influences your valuation as the underlying free cash flows change based on the scenario you use.
The valuation based on the DCF-method is also heavily dependent on the adopted WACC percentage (recall: the risk indicator) and the growth rate that you use for the calculation of the terminal value. As the risk of not achieving the expected earnings is relatively high for a startup (unless you have a stable business with positive financial results for a few years already) it’s better to set your WACC higher than lower (> 25%).
You can find an example of WACC percentages (cost of capital) per sector in the U.S. here. These percentages are in the range of five to eight percent, but are based on large stable corporations which generally have a much lower risk compared to startups. You can play with the WACC and the expected growth rate to see how it affects your startup valuation.
