Question

1. What is the more accurate method of valuation, DCF or VC method?
2. Where is the biggest possibility for error in the VC method?
3. Why is DCF prejudiced?

Answer 1

What is the more accurate method of valuation, DCF or VC method?

Concepts: Discounted Cash Flow: The Discounted Cash Flow method consider free cash flows generated in the future by a specific project and discount them to derive the present value. it usually used to estimate the value of potential investments. when Discounted cash flows calculations produce values that are higher than the initial investment, this usually indicates that the investment may be worthwhile and should be considered.

Venture capital method : The venture capital method reflects the process of investors where they are looking for an exit within 4 to 8 years. First an expected exit price for the investment is estimates . from there one calculates back to the post money valuation today taking into account the time and the risk the investors takes. The venture capital method is an often used in valuations of pre-revenue companies where it is easier to estimate a potential exit value once certain milestone  are reached.

Comparison of DCF and VC

The more accurate method as compared to both valuation i.e Discounted Cash Flow as compared to Venture capital Method. One of the Strength of Discounted cash Flow analysis is that it takes account of time value of money, which is very important with projects that are long term and variable length. that is less in venture capital method.

Where is the biggest possibility for error in the VC method?

The VC Method is a dominant method used in early stage of investment, has numerous shortfalls. Such as :

1. it requires reliance on projected growth and future revenues.
2. it is income based valuation model.
3. Projecting company revenue at a future date is extremely difficult and speculative.
4. it relies upon valuation multiples in deriving a terminal valuation.
5. Its calculation based on market situation.Future market situation is uncertain.
6. there is no fixed method of assessing risk associated with the business.

Why is DCF prejudiced?

The Discounted Cash Flow valuation method is prejudiced is that it is easily prone to errors , cause of wrong assumptions and over confidence what a project is actually worth. The Following are the drawbacks of DCF Model.

1. It requires large number of assumptions.
2. it is very sensitive to change assumptions.
3. it looks at company valuation in isolation.
4. it does not consider the market competitor.
5. Terminal value is hard to estimate and represent a large portion of total value.

DCF analysis is best used with other tools in order to have check and balance mechanism to validate the result