50 QuestionsVenture Capital

Why discounted cash flow analysis isn’t appropriate for startups

By May 27, 2011 4 Comments

image Bill Gurley put a great post up on Tuesday which discusses valuation drivers, and why different businesses achieve very different revenue multiples.  It is no coincidence that he covers much of the same ground as I did in last week’s 50 Questions post on barriers to entry.

The whole post is a good read, but the piece I want to pick out is his explanation of why discounted cash flow analysis isn’t appropriate for startups.  I consider myself a financial purist and would value businesses on discounted cash flows if I thought it worked, but I don’t and wrote about my reasons for not doing so back in March.  This excerpt from Bill’s post is a simpler and less technical explanation than mine (and hats off to him for that 🙂 ):

Those of us with a fondness for finance will argue until we are blue in the face that discounted cash flows (DCF) are the true drivers of value for any financial asset, companies included. The problem is that it is nearly impossible to predict with any accuracy what the long-term cash flows are for a given company; especially a company that is young or that might be using an innovative and new business model. Additionally, knowing what long-term cash flows look like requires knowledge of a vast number of disparate future variables. What is the long-term growth rate? What is the long-term operating margin? How long will this company hold off competition? How much will they be required to reinvest? Therefore, from a purely practical view, the DCF is an unruly valuation tool for young companies. This is not because it is a bad theoretical framework; it is because we don’t have accurate inputs. Garbage in, garbage out.

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