An Overview of Discounted Cash Flow Valuation Method

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One popular method of valuing tech companies is discounted cash flow (DCF). This method is deeply rooted in finance and is built on the premise that a company is worth the present value of all the cash it will generate in future.

To calculate the value of a company using DCF, investors first determine the revenue the company is currently generating. They then deduct expenses (operational, interest, and capital expenses) as well as taxes to get the cash it is currently earning.

Afterward, investors use growth projections to estimate the company’s net cash flows years into the future, typically five years out. Once they have projected earnings for each of the coming five years, they apply a discount rate on each year to get the present value of this cash, taking into account inflation.

Usually, the discount rate is the interest cost on debt capital. However, some investors use different rates in line with how risky they see the business or their preferred rate of return. Generally, the higher the discount rate, the riskier investors see the business. Hence, established businesses often get low discount rates while startups get high rates.

Afterward, investors add the present value of the future cash flows. This is the value of the business today. It’s worth noting that investors have to take cognizance of several factors while using DCF. An example is rapid technological advancements that may increase or disrupt earnings. Economic and regulatory changes may also affect future cash flows.

Graham R Taylor

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