4.4. Discounted Cash Flow Analysis

We previewed DCF analysis at the end of the previous chapter. It’s a direct valuation method that attempts to measure a company’s intrinsic value by (1) making a prediction about the company’s future cash flow, and (2) discounting that cash flow to present value. Because a series of present values are added together, the formula resembles the NPV formula. However, unlike the NPV formula, the cost of the initial investment is not deducted.

A DCF analysis will produce a range of implied EVs, not implied equity values. This is because the measure of cash flow typically used in a DCF analysis is free cash flow to the firm (FCFF), and the cash flow is discounted using weighted average cost of capital (WACC). Neither FCFF nor WACC are metrics that are specific to equity (see the discussion of metrics related to EV versus metrics related to equity value).

DCF analysis is less useful for new companies, because their cash flow is harder to predict. For this reason, it is the least likely valuation method to be used by venture capital firms.

A DCF analysis includes the following steps:

Step 1: Estimate future cash flow. As with the other valuation methods we have discussed, the first step of a DCF analysis requires gaining an overall understanding of the target company’s business and financial profiles, historical performance, and estimated future outlook. A good place to start is by looking at the last three years’ worth of the target company’s earnings and profitability metrics. You should also look at trends and expected growth rates in the target company’s industry. This will help you to develop a better understanding of the strength of the target company. Suppose the target company has been overperforming or underperforming relative to its industry as a whole. Do independent analysts agree about why this is? Knowing this may shed light on how reasonable it is to project that the trend will continue.

Once