Question

What are the main challenges and difficulties in finding a value using the FCF method of valuation for a startup that has little historical data? What do you do to value a startup using the FCF method of valuation? Explain in needed details please.

Answer 1

FCF(Free Cash Flow Method) exists outside the realm of audited statements meaning that auditors don’t have to look at the figures reported by the management. The standard calculation of FCF taught in school is take cash flow produced from operations and deduct cash spent on capital expenditure and other long term investments. Complications occur when cash flows are normalized for investment purposes. For instance a company’s payout ratio is important to analyze annually because it demonstrates what portion of cash flows are being paid to investors as dividends. A company with a payout ratio of close to 100% will have no room for performing additional investment maintenance and cannot absorb a hit to revenue or cash flows without eventually impacting dividends.

With so much attention focused on payout ratios, investors cannot forget the advisor in the equation (FCF) is open to interpretation. Some companies will find ways to maximize FCF in order to reduce their payout ratios, making it appear they have greater cash flow coverage for dividends.

Start-up represents the initial stage after a business have been formed. The product is generally still untested and does not have an established market.

As every valuation method based on the future discounted cash flow is the methodology of future cash flow actualization. It transforms future cash flows in their equivalent value today. The main underlying assumptions of this methodology is that money tomorrow is worth less than money today.

Indeed , startups are much more prone to fail than accomplished public companies. For this matter valuing early stage companies requires the valuator to stress such risk when computing in a much more prominent way. These failure rates strongly influence financial forecasts indeed from the stand point of an investor that has average knowledge of the business , there is no reason to believe that this particular company has higher success rate than others.

However when considering these main factors we can understand how a better use of DCF can not only expand its usefulness in early stage companies and when evaluating the possible return of single investment and portfolios.