Mckinsey Dcf Valuation Model [UPDATED]
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The Valuation 6e DCF Model comes in two formats -- the Web Download Edition and the CD-ROM Edition. In either format, the Valuation 6e DCF Model is a vital companion to Valuation 6e, containing expert guide and the renowned discounted cash flow (DCF) valuation model developed by McKinsey's own finance practice. The DCF Model can be used to value real companies in real-world situations, and includes detailed instruction and expert guidance on how to use it. The advantage of the ready-made model is that allows users to focus on analyzing a company's performance instead of worrying about computation errors.
Tim Koller (New York, NY) is a partner in McKinsey's New York office. Tim has served clients in North America and Europe on corporate strategy and issues concerning capital markets, M&A transactions, and value-based management. He leads the firm's research activities in valuation and capital markets issues.
David Wessels (Philadelphia, PA) is an adjunct Professor of Finance and director of executive education at the Wharton School of the University of Pennsylvania. Named by BusinessWeek as one of America's top business school instructors, he teaches corporate valuation at the MBA and Executive MBA levels.
Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the financial model, as it typically makes up a large percentage of the total value of a business. There are two approaches to the DCF terminal value formula: (1) perpetual growth, and (2) exit multiple.
The exit multiple approach is more common among industry professionals, as they prefer to compare the value of a business to something they can observe in the market. You will hear more talk about the perpetual growth model among academics since it has more theory behind it. Some industry practitioners will take a hybrid approach and use an average of both.
As you will notice, the terminal value represents a very large proportion of the total Free Cash Flow to the Firm (FCFF). In fact, it represents approximately three times as much cash flow as the forecast period. For this reason, DCF models are very sensitive to assumptions that are made about terminal value.
TIM KOLLER is a partner in McKinsey's New York office. Tim has served clients in North America and Europe on corporate strategy and issues concerning capital markets, M&A transactions, and value-based management. He leads the firm's research activities in valuation and capital markets issues. He received his MBA from the University of Chicago. MARC GOEDHART is a senior expert in McKinsey's Amsterdam office. Marc has served clients across Europe on portfolio restructuring, issues concerning capital markets, and M&A transactions. He received a PhD in finance from Erasmus University Rotterdam. DAVID WESSELS is an adjunct professor of finance and director of executive education at the Wharton School of the University of Pennsylvania. Named by BusinessWeek as one of America's top business school instructors, he teaches corporate valuation at the MBA and Executive MBA levels. David received his PhD from the University of California at Los Angeles.
By combining the dynamic flexibility of a DCF Model Download with the depth and breadth of a classic text, this package will help you hone your valuation skills today and improve them for years to come.
TIM KOLLER is a partner in McKinsey's New York office. Tim has served clients in North America and Europe on corporate strategy and issues concerning capital markets, M&A transactions, and value-based management. He leads the firm's research activities in valuation and capital markets issues. He received his MBA from the University of Chicago.
DAVID WESSELS is an adjunct professor of finance and director of executive education at the Wharton School of the University of Pennsylvania. Named by BusinessWeek as one of America's top business school instructors, he teaches corporate valuation at the MBA and Executive MBA levels. David received his PhD from the University of California at Los Angeles.
During the (pre-)seed stage it is not uncommon for startups to not generate revenues at all whilst discussions regarding equity transfers, ownership percentages and the accompanying valuation already arise. The DCF-method is then especially suitable as it weighs future performance more than the status quo of your startup.
Before we scare you away with the formula of the DCF-method, it is important to understand the underlying assumptions of this technique. (Startup) valuation on the basis of the DCF-method is based on two main assumptions.
In order to perform a valuation for your startup using the DCF-method you will need to forecast your future financial performance. In the DCF-method you present this performance as the future free cash flows (see step 2). This is usually done for the next five (or sometimes ten) years.
The calculation of the free cash flows is not complicated, but you need a couple of ingredients in order to be able to perform the calculation. If you want to perform a DCF-valuation you will need to create a financial plan/model in order to come with all the required elements.
In a financial model you project your revenue streams, costs, expenses and investments for the years ahead. These come together in a financial overview in which you present a prognosis of your financial statements (profit & loss, balance sheet, cash flow statement) and the predominant main Key Performance Indicators (KPIs) for your firm.
A financial advisor can help you with creating your financial model. However, if you feel confident doing this yourself it is good to know that there are many online Microsoft Excel templates available which you can modify and that there are also online tools (such as EY Finance Navigator) which can help you with this. If you want a deep-dive into financial modeling, you can check out our ultimate guide to financial modeling for startups.
Below you will find an example of a valuation according to the DCF-method. The valuation (within the red borders) of this fictional example was made on January 1st 2017 on the basis of a five year prognosis.
Et Voilà! The most time consuming step in the process of valuing your startup by using the DCF-method has been performed: the calculation of free cash flows. Now you know the future earnings that are the basis for your valuation.
As you may have noticed, you can find the ingredients required for such a calculation in various parts of your financial statements (profit & loss statement, balance sheet and statement of cash flows). That is why a complete financial model is crucial when applying the DCF-method for valuing your startup.
In essence the WACC is a percentage and is (in the context of valuating a startup) a way to define the risk an investor is taking when he/she invests in a firm. The higher the WACC percentage, the higher the risk and the lower the valuation of your firm. As investing in startups is risky to begin with, it is not strange to see high WACC percentages for such firms.
So, what do you need the WACC for anyway? With the WACC you calculate the discount factor. The discount factor determines the present value of your future cash flows, in other words: your valuation! The discount factor is calculated using the formula below, per year:
The number of the time period is in this case the specific year of your forecast. In our valuation example above 2017 is time period number one, 2018 is number two, and so on. In the blue-bordered section you will see that when the WACC is 15% (using the formula above), the discount factor is 0.87 in 2017 and 0.50 in 2021.
Moreover, given the discount factor formula above, the higher the WACC %, the lower the discount factor, which in turn means a lower monetary value of the cash flows. This illustrates how a higher risk of investing (a higher WACC) also reduces the value of the cash flows and thereby the valuation.
The hard work is over! One last sum and your startup valuation is finished. In step four you have calculated the net present value of all future cash flows (including the Terminal Value). When you add all these values (as done in the green section below) you arrive at the value of your startup on the basis of the DCF-method (orange bordered in the overview below).
This provides you with insights in the performance of your firm when things do not go as expected, for better or worse. This influences your valuation as the underlying free cash flows change based on the scenario you use.
You can find an example of WACC percentages (cost of capital) per sector in the U.S. here. These percentages are in the range of five to eight percent, but are based on large stable corporations which generally have a much lower risk compared to startups. You can play with the WACC and the expected growth rate to see how it affects your startup valuation.
And that precisely illustrates the challenge of performing startup valuations. For well-established firms it is easier to create forecasts as you can extrapolate historical information that provides a reasonable level of certainty. A startup generally does not have much historical financial information yet. A pre-revenue startup even has no revenues yet. So how can it predict future earnings without having achieved one sale yet? For this reason it is crucial to create a proper financial model.
On the one hand the DCF method is convenient for startup valuation as it uses future earnings. Perfect for a startup where most financial value is generated in the future. However, there are also startup-specific disadvantages related to the use of the DCF-method: the valuation is highly dependent on the quality of the financial forecasts and choices related to input variables such as the WACC and growth rate.
Before concluding this article we would like to stress that a DCF valuation is not the same as the actual sales price of your firm when you try to raise equity funding! Despite all your efforts and research in applying the different valuation techniques available, the value of (a share of) your startup is eventually determined by the negotiations with an investor and the share he/she receives in return for investing in your company. Hence do not anchor too much on the results of performing a mathematical exercise. 2b1af7f3a8