The discounted cash flow method for valuing a startup

What is the discounted cash flow (DCF) method?

Investors use the discounted cash flow method (DCF) to calculate their rate of return over time. It’s effective for startups because it uses cash flow forecasting, not existing income or assets. The accuracy of those projections is critical. DCF also uses a discount rate, typically the weighted average cost of capital (WACC). Here’s the DCF formula:

DCF = [CF1/(1+r)1 ] + [CF2/(1+r)2 ] + [CFn/(1+r)n ]

The “r” variable is the discount rate. Each subscript and superscript number represents the year projected (1st, 2nd, etc.), so the first year is CF1 divided by (1+r)1. In the second year, the (1+r) is squared. In year three, it’s cubed. The “n” represents a placeholder for whatever year is being calculated. This gets less complicated when you plug in the numbers. 

DCF analysis discounts future cash flows because the time value of money changes. For a real-life example of this, look at real estate. A home bought ten years ago for $350,000 could be selling for $480,000 in 2025. That means your $1 from 2015 has a net present value of roughly 73¢ today. DCF valuation calculates future or terminal value based on the same principle.

Challenges with startup cash flow forecasting

Look at the discounted cash flow formula again. It’s asking you to calculate your cash flow on a year-by-year basis. That’s difficult to do when you’re a startup because revenue and cash flow may not be established. The DCF method requires cash flow projections based on the value of the business and expected demand for your products and services. 

Another challenge for a startup is predicting the growth rate of the company. Financial modeling based on the initial investment and burn rate is good for planning pre-revenue stages, but it doesn’t give you an accurate picture of post-revenue cash flow. Your team must work on a cash flow model before determining an appropriate discount rate. 

Many entrepreneurs use a comparable company analysis to fill in the blanks. This type of financial modeling can be insightful but doesn’t give you the whole picture. Comparing a past time period with a future period is tricky. Inflation, market demand, and technology innovation are three variables that could significantly distort the numbers. 

Using WACC as a discount rate

Weighted average cost of capital (WACC) is commonly used as a discount rate because it encapsulates risk by adding up the cost of equity and debt. These variables are liabilities that affect the balance sheet and cash flow statement Those are essential for calculating a DCF valuation because they directly affect future cash flows. 

Capital expenditures are not included in WACC. They are used for cash flow projections in the DCF model. The interest rate you pay on debt is part of the WACC equation. Not adjusting for fixed and variable rates is a common mistake. Hire a financial or accounting professional to do a discounted cash flow valuation because of these potential pitfalls.  

The weighted average cost of capital formula incorporates several variables that must be calculated before being plugged in. One is the Capital Asset Pricing Model (CAPM) which uses a risk-free beta rate for stock volatility. That helps stabilize the formula but may skew the numbers if volatility is high. It’s important to keep that in mind when doing a valuation.        

Net present value (NPV) as a DCF output

The DCF calculation produces a net present value (NPV) for a startup. This number represents the expected cash inflows and outflows discounted to present-day values. If the NPV is positive, the company is worth more than its current book value. That’s attractive to investors. If the NPV is negative, your company has a cash flow problem.

In simpler terms, the DCF valuation model calculates the present value of a future stream of cash flows. That output (NPV) tells prospective shareholders if your business is a good investment opportunity. It’s used in financial analysis to calculate the internal rate of return (IRR) and future value of cash. It’s also widely used in investment banking. 

Startups use NPV to help investors calculate a required rate of return to justify their investment. This is critical for every fundraising stage, from seed funding to IPO or sale. Focus on getting it right because the initial results will be scrutinized as your firm evolves. Actual cash flows within a small margin of error from cash flow projections are the mark of a well-run company.    

The role of terminal value

Terminal value (TV) is the projected worth of a business beyond the forecast period. Startups with high growth potential are often evaluated based on this number. Two ways to calculate TV are the perpetual growth method, which assumes cash flows will grow at the same rate in perpetuity, and comparable company analysis, which we’ve already covered. 

The terminal value can be discounted back to present levels using the discounted cash flow method. This can be easily seen on an Excel spreadsheet, a tool you can also keep track of interest rates, growth rates, capital expenditures, and financial ratios. Those numbers will be useful if you want to compare other valuation scenarios.    

Comparing DCF with other valuation methods

The discounted cash flow method is a powerful tool for startups, but it's not the only valuation option available. No projection is infallible, so it’s prudent to do additional valuations using different methodologies. For best results, calculate your NPV using DCF valuation, then compare the results to what you get using any or all of the following:

• Comparable Company Analysis (CCA): We’ve mentioned CCA several times. It uses market data from similar companies to project future cash flows at your business. This is typically a good starting place, but it’s not a comprehensive analysis. 
• Precedent Transactions Analysis (PTA): Like CCA, the precedent transactions analysis only provides a partial analysis. PTA evaluates past acquisitions in the industry, making it a useful complement to comparable company analysis. 
• Dividend Discount Model (DDM): The dividend discount model is useful for firms that pay consistent dividends. It’s based on the assumption that the present-day price of a stock should be equal to the discounted value of all its future dividend payments. 

Each method has its strengths, and DCF modeling is often used alongside others to determine the fair value of a startup. Using a comparative approach could reveal errors or omissions in the original DCF calculation.

Conclusion: Is the DCF method right for startup valuation?

The discounted cash flow method has its challenges, but it’s a valuable tool for assessing the equity and enterprise value of a startup. By accurately estimating future cash flows, and applying the right discount rate, investors and analysts can use the NPV output to make informed decisions about the value of an investment. 

You can leverage it alongside other methodologies to better understand your financial standing.