Why doesn't a conventional DCF not work for valuing a start-up/young firm?
The basic building blocks on spreading a DCF involves four main aspects
1) Cash generation from existing asset base
2) Expected growth from new investments and new efficiencies on existing asset base
3) Risk assessment at firm level or equity levels leading to appropriate discounting factors (WACC or Ke)
4) Assessing when the firm achieves a stable growth and thereby estimating the Terminal Value
For a young firm, there are following bottlenecks while using the traditional approach
1) Lack of historical data: Scarce historical financial data makes it difficult to estimate the consistency of revenue generation from existing asset base especially when macroeconomic conditions/competition/pricing policies become unfavorable
2) Operating Margin estimations: Most of the start-ups have no or limited revenue in the initial years leading to losses. With no history in hand, it becomes difficult to assess what the margins of the business will be in the future
3) Quality of earnings/growth: Value estimation depends largely on the quality of growth that a firm is capable of generating. Value creating growth arises only when the ROC> cost of capital on the growth assets.
For start-ups, due to limited history or fewer investments the ROC is generally negative giving a tough time to understand the quality of growth achieved
I will continue on the other sections of the DCF in my upcoming posts and highlight the shortcomings of the conventional DCF for valuing a startup/young firm valuations.