Steps to Growth Capital Self-Study GuideStep 3

3.7 Discounted Cash Flow Value

The prevalent method for valuing firms for investment purposes is the discounted cash flow approach. This complex accounting procedure is used to answer three critical questions:

Value

How much is a company worth today, based on what it will earn in the future?

 

Rate of return

What is an investor's expected rate of return, given the amount invested and the company's financial projections?

 

Equity share

How much equity will the investor receive for the investment?

The discounted cash flow method is preferred because it can be more accurate than other methods. Its accuracy and complexity are due to the fact that it:

• uses cash flows — which are the projected ups and downs of revenue over a period of time; and
  
• discounts the cash flows — in other words, it adjusts the cash flows by a rate that is acceptable to the investor to account for risk and the time the investor must wait for a return.

Why Discount?

In this method, cash flow predictions are discounted, or reduced, to adjust for the risk the investor faces and to make up for the fact that the investor could invest the money in something else.

The underlying idea of a discounted cash flow is that $100 today is worth more than $100 a year from now. In fact, $100 today is equal to $110 next year or $161 in five years, if you accept an interest rate of 10% per year. One hundred dollars in the present is equivalent to $161 in the future because the $100 you have today can be invested to earn interest and there is no risk you may not receive it. This idea is called the "time value of money", and it is the basis of the discounting method.

What Investors Want to Know

Investors will ask you: "Why should I give you $100 today?" Your answer must be that you can offer a return of significantly more than $161 in five years. If you can't do that, the investor is not going to be attracted to your investment, because simply taking compound interest at 10% would yield that much.

Investors are looking to be compensated for their risk, and their benchmark rate — or "discount rate" — will adjust for the time value of money. They will choose a discount rate and compare your proposal against that rate.

The Pluses and the Minuses of Discounted Cash Flow

The discounted cash flow method is very effective because it allows values to be determined even when cash flows are fluctuating. A start-up or new venture may expect to lose money in the first years and then make money in later years. These changes in cash flows are taken into account by the discounted cash flow method.

The method has several disadvantages:

• Its accuracy depends on the accuracy of the cash flow projections. That's why your financial data and assumptions are so critical.
  
• It's a complex process that requires specialized expertise to perform. This is an area where outside help is almost always needed.
  
• It produces precise numbers that appear very solid. But these are still just estimates, depending on the underlying assumptions, the discount rate used, etc. Don't be fooled by the definite values of the numbers.

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