Discounted Cash Flows

Musings of a VC Intern

18/02/2025

DCFs, NPV, LBO, EBITDA and so many more finance terms are thrown around daily here and there.

Today let’s delve into DCFs first. Discounted Cash Flow is a financial model that helps evaluate how much a company will be worth in the future or its NPV by analyzing financial statements. There are often key assumptions in place such as growth potentials and expenses. A financial model is never accurate but they are there as a metric to roughly gauge how much our company can be worth in the future. Often this is done by analyzing at least the past three years and estimating growth rates. By determining this values we can arrive at a terminal value. This terminal value is the price which the company will be worth in the future by x number of years. Depending on the value of this terminal value people will evaluate whether it is a worthwhile investment.

We then talk about WACC, weighted average cost of capital. This is the weighting of future costs and benefits to reflect the time value of money. This is because money decreases in value due to inflation, we also have to consider interest rates if we borrowed said money to invest in the company and grow it. Assuming an interest rate of 4% and an inflation rate of 3%, our WACC is 7.12% per year. Lets say this spans a 5 year period, our net present value based on the DCF would have to be a minimum of 41.04% larger than the initial capital before we can consider the investment even profitable.

Furthermore private equity investors would look for higher returns. Assuming we negate the interest rates because these people invested money in us so we dont technically owe them, and also the inflation rate is not accounted for as they will be wanting to see value of the investment against other companies or for example SnP500. So lets say a return of at least 15% per annum. Thus, we would have to return 101.2% larger than the initial investment for them to consider an investment.

There are also dividends we can consider into play. Assuming we give out 1% as dividends per annum and they want a 10% return rate. Now you try and do the math this time.

So every year the discount factor will change because it is further from your present and the value of that money will drop in a discounting manner. By estimating these cashflows using the potential discount rate, we can derive how much capital we can gain each year from the investments in net present value terms.

But wait if the company has a steady income and growth potential can’t you sell it off for more money? Exactly, that is where terminal value comes into play. There will be a sensitive factor known as your growth rate in growing perpetuity. You can take a rate of let’s say 5% a year. Or you can evaluate it using Enterprise Value (EV) multiples, which essentially shows you how much other companies similar to your own is worth. Often times this is very industry centric and will sway largely accordingly. With that, now we can value our company accordingly.