The valuation of a business is a critical element that depending on the accuracy of the valuation can be the difference between large positive returns or devastating losses for investors. The importance of valuation is why differing methods are always being debated and analyzed. The valuation of traditional companies with historical data and comparative industry examples can be a bit confusing for the average person but with practice they really are not overly complicated. The discounted cash flow method, or DCF, is a widely academically accepted method that uses the concept of the time value of money to discount future expected cash flows. While often these DCF calculations can be fairly straightforward, there are instances where estimating future cash flows can be quite difficult. Startup companies pose significant challenges to the discounted cash flow model because of a lack of historical data. It may not be difficult to estimate future cash flows for a billion dollar company with years of data, but what about a 6 month old company with limited revenue and few tangible assets? In situations like this it is more important than ever for investors to look beyond numbers and to look deeper into the makeup of a company, its management, and their products or services.
Difficulties in Using DCF to Value Startup Companies With discounted cash flows and almost all other valuation techniques, the less guesswork or estimation the better. The “Human Element” when making critical assumptions like growth rate can be affected by biases including excessive optimism and overconfidence. “Biases in traditional discounted cash flow valuation arise in connection with the cash flows themselves, for example, excessive optimism, or misframing, as is the case with the way free cash flows are defined” (Shefrin 2007). Excessive optimism is a bias as it relates