Question

what are the main steps to follow when you are projecting valuation of a company using Discounted Cash Flow Methods? What assumptions you may need to make in order to complete your valuation process for a start up company which data you may alreayd have in hand?

Answer 1

Valuation of a company by discounted cash flow is done by discounting the after-tax free cash flow at a risk-adjusted discount rate. The appropriate discount rate used to discount the after-tax free cash flow of the firm is the weighted average cost of capital (WACC) which is calculated by following formula:

WACC = r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)

Where, r(E), r(P) and r(D) are cost of equity, preferred stock and cost of debt, w(E), w(P) and W(D) are weight of equity, preferred stock and debt and t is the tax rate.

Cost of equity is estimated using either CAPM or dividend growth model. Cost of debt is the Yield to maturity of the debt and preferred share cost is calculated by dividing the annual dividends by the price of preferred stocks.

The after-tax free cash flow can be calculated using following formula:

Free Cash Flow = Operating Cash Flow - Capital Expenditures - Change in working capital
Operating Cash Flow = EBIT*(1-Tax Rate)+Depreciation

DCF valuation depends on the estimation of free cash flow and discount rate. Estimating free cash flow and discount rate accurately for a startup will be difficult as it doesn't have any track record. Therefore higher discount rates are used for a startup to adjust for the high risk of free cash flows in future.