“What’s your current valuation?” It sometimes seemed to me that when I met new people in the start-up scene, they asked for my name, what my company does and then they immediately jump to that question. I personally found it very awkward to ask such a question, as there is no need to walk around running a private company and telling everyone about my company’s value.
However, when you plan to raise money, the company valuation is key. It is one of the most important figures investors look for in a start-up. There are many ways to calculate a business valuation – public companies can use their market capitalization, you may look at book value or earnings multipliers. In this post, I am focussing on the most popular method for start-ups: the Discounted Cash Flow (DFC) Method.
The DCF analyses future free cash flows (FCF) and discounts them. It helps investors estimate the they would receive by investing in the company today by adjusting it for the time value of capital.
Therefore, as a first step we need to talk about what is the free cash flow (FCF)? The FCF is the cash flow which is available to the investors of your company after investments in your fixed assets or working capital (your capital expenditures (CAPEX). If the FCF is positive and increases, it is seen as a sign for a healthy company. (Note: However, a negative FCF does not have to be interpreted as a bad thing. It may mean that the company plans to expand and makes investments to grow.)
Because of this meaning, the FCF is an important indicator for investments. How can we calculate the FCF? There are different ways to calculate the FCF. I personally prefer the following method:
Similar to the projections in your balance sheet or profit and loss statement, you will need projections for the FCF. This sounds really theoretical. I made an example in Excel for you to make it more hands on.
Let’s say that our EBIT is USD 1 billion in the first year and that we are doing a 10-year-projection. (See how to calculate EBIT in my post here.) After that, we assume a yearly EBIT-growth rate of 5%. Now we apply the above-mentioned formula to get our yearly FCF. The tax rate is assumed at 30%, deprecation and CAPEX of EBIT at 10% respectively and the change in working capital* is 20%.
After a certain period of time, it becomes quite challenging to forecast your company’s growth in detail. Therefore, investors use a simple assumption: they assume that after a certain point time, your company will grow at a stable rate forever. They use these projections to forecast your so-called “terminal value” (TV). In this case the value of the company as it continues into perpetuity.
Your TV is based on your final year’s one year forward FCF. In our case, we grow the final year (year 10) EBIT by 3%, our stable growth rate. Your TV is the final year’s free cash flow multiplied by the perpetual growth rate divided by the difference of the discount rate (Weighted Average Cost of Capital (WACC), read more about it here) and the stable growth rate.
In our example, we use a WACC of 15% and a stable growth rate of 3%. The TV is based on the next year’s FCF into perpetuity. Therefore, we need to multiply the last year’s FCF by our perpetual growth rate.
The TV is USD 9.705 billion.
Now we have the future FCFs and the terminal value. We still need to discount them to get their value today. This is called the “present value” (PV). We need the WACC again to discount the FCFs and the TV.
(Note: The terminal Value is discounted for 10 years in this example because the stable growth rate was assumed to start after year 10.)
After discounting the cash flows, the value is assessed against the investment cost we face at the moment for the project. If the value is higher than the cost, it can be a good investment. In our example, the present value is more than USD 6 billion.
Today we managed to calculate one of the most important indicators for investors. Do you still have any questions? Don’t be shy and ask in the comments or send me an e-mail. These are very abstract and technical concepts for newbies, it takes some time to understand them. Don’t give up! 🙂
* Note: “Change in working capital” looks at how you are using and collecting cash. Sales are sometimes done on credit, 30-90 days for example. So when you sell something, you book the sale but not the cash inflow. Similarly, when you buy something, you book the expense but not the cash outflow. Working capital is the difference between your receivables (money that people owe you) and payables (money that you owe to others). It is a minus sign because working capital is receivables less payables, but if you are taking alot longer to pay your suppliers that is actually a form of cash reserves so you need to add that to your overall cash balance. That is done by subtracting change in working capital.
This is a brief overview and example of how to calculate financial indicators for your use of funds for your business plan. There are many ways to do it and for matters of simplification, I published the methods I personally used before. Every business and product is unique. So are the financials. Hence, there is no one-size-fits-all approach and the methods have to be adapted case by case. I recommend talking to your auditor/financial advisor about the details of your case.