Venture Capital

April 28, 2021

Discounted Cash Flow (“DCF”) models are used to generate equity valuations for companies that are generating positive free cash flows. Given that the generation of positive cash flows is often achieved at later stages of a company’s development (notably this valuation technique is used by public equity analysts), DCF models are appropriate only for these later-stage companies.

An important distinction must be made between cash flows and earnings. It is possible a company can generate positive earnings (i.e. income less expenses) and negative cash flows (and vice versa) due to the differences in how these metrics are calculated.

Earnings (or Income, Net Income, etc.) are simply the accounting calculations of all revenues minus all expenses, inclusive of non-cash items such as depreciation, amortization, or other non-cash expenses.

Cash flows, on the other hand, represent the actual increase or decrease in cash generated by the company over an accounting cycle and are calculated by starting with the net income and adding back non-cash expenses (to simplify things).

Why does this matter? The value of any financial asset is nothing more than the discounted value of all future *cash flows*. That’s what a Discounted Cash Flow model does: it projects the future cash flows and discounts them backwards to an implied value today.

Typically, early stage (i.e. pre-revenue or pre-cash flow) will rely on industry or competitor multiples, or other methodologies, that do not require positive earnings for cash flows. Given the highly variable nature and risk of early-stage companies, peer analysis and multiples are a more common and appropriate valuation estimation.

The GoingVC DCF model, therefore, uses current and past financial statement data to generate cash flows and allows the user to make growth and margin assumptions to project and then discount these estimated future cash flows to derive an equity valuation.

Once you’ve downloaded and opened the model, navigate to the ‘Inputs>>’ tab. Here you can update the implied values used within the model:

**Discount Rate**= This is the rate used to walk-back the future values to today’s values. It essentially represents the (implied or opportunity) cost of investing, or can be thought of as the minimum required rate of return or estimated growth rate. Effectively, the discount rate can be used to determine the value of a cash flow in the future, today.**Terminal Rate**= This is the long-term estimate growth rate of the company in maturity. Financial theory assumes that over the (very) long term, companies grow at the rate of inflation + a spread, and therefore most analysts use a low, long term growth rate to capture the cash flows from the end of the model into the essentially infinite future.**EBITDA Exit Multiple:**Our model also includes an EBITDA valuation as both a check and scenario analysis estimation of value. We prefer using EBITDA in order to rid the valuation basis of accounting, capital structure, and tax affects — making comparisons across business models, sectors, and types more relevant.

The next three tabs, Income Statement, Balance Sheet, and Cash Flow Statement, require user input of previous financial statement data (up to five years). The orange cells require user input.

The last worksheet that requires updating is the DCF Model tab. Cell C1 enables the user to toggle between the Base Case and the Down Case. The differences between these two cases are derived from the inputs from the user in the relevant boxes below, in columns B through F:

Those highlighted above in blue text allow a user to input the assumed growth or margin rates during the first 1–5 years of the model, then the next 6–10 years. This allows for a two-step growth assumption: higher during earlier years and potential slower during later years, if desired.

For each value, the trailing 5 year average is calculated to present a baseline estimate, which can be adjusted as mentioned above. The ‘Adjuster’ value is simply the difference between the Base Case and Down Case values. For example, if you assume Revenue Growth of 10% as your Base Case and want a Down Case value of 2%, the adjuster value would be 8%. Similarly on margins, if you want a Base Case Gross Profit Margin of 60% and a Down Case Value of 50%, the adjuster for the Cost of Goods (% of Revenue) would be 10% (the model implied good vs bad in terms of positive or negative adjustments).

Once all the inputs have been completed, the rest of the model updates:

**Ratio Analysis**: This calculates various ratios across the income statement, balance sheet, and cash flow statement.**Financial Statements**: Clean statements from the input data.**Dashboard**: The implied valuations using the assumed discount, terminal, and EBITDA Exit Multiple values, with an option to change the valuations for side-by-side comparison.

There are also a wealth of other charts that look at profitability, efficiency, financial health, returns, and cash flows with various estimated target metrics for analysis.