Question

Our typical valuation tools rely on either discounting future cash flows of the firm or using multiples of EBITDA (based on observable comparable firms).How well would these tools work if the firm is many years away from positive free cash flow and currently has negative EBITDA or has positive EBITDA but is expected to grow much more quickly than observable comps?

Answer 1

Present Value of the expected future cash flows is derived using a discount rate.One of the biggest challenge is finding the right discount rate and estimating the cash flows with certainty.

Now if the firm is many years away from positive cash flow and at present the cash flows are negative, then going strictly by the principle of this model, it would not suggest to make an investment . With changing times, the business models have changed leaps and bounds. The start-ups vouch for innovative techniques and heavy investment in technology and they bleed a lot in the initial years. The break even would be many years away. However, investment not only relies on cash flows but also conviction and confidence on the business model and other qualitative factors.

The DCF tool or Comparable tools will not give accurate results needed for decision making if the assumptions we make are not correct or in line with reality. Negative cash flows or far too many years from achieving positive cash flows will straight away give a “Avoid” decision going by the technicalities of the tool.

Also in case of other comparable firms, if the firm under consideration is expected to grow rapidly then the growth rate has to be factored in rather than just looking at the ratios. A firm can be an outlier compared to industry average and it should be taken into consideration while making an investment decision rather than just looking at the quantitative factors.