Discounted Cash Flow (DCF) is a fundamental valuation method that calculates the present value of a company by projecting its future cash flows and discounting them back to today's dollars using a specified discount rate. This approach rests on the principle that a dollar received in the future is worth less than a dollar today due to opportunity cost, inflation, and risk.
The DCF model involves forecasting a company's free cash flows over a specific period (typically 5-10 years), then calculating a terminal value to capture the worth of all cash flows beyond the projection period. Each projected cash flow is then divided by (1 + discount rate)^n, where n represents the number of years in the future. The sum of these discounted values represents the company's intrinsic value.
Why It Matters
For angel investors, DCF analysis provides a data-driven framework for determining whether a startup's asking price aligns with its fundamental value. Unlike market-based valuation methods that rely on comparable companies, DCF focuses exclusively on the target company's expected performance, making it particularly useful when evaluating innovative ventures without clear comparables. The model forces investors to examine critical assumptions about growth rates, profit margins, and risk, revealing which factors most significantly impact valuation and where due diligence should focus.
Example
An angel investor evaluates a SaaS startup seeking $2 million at a $10 million pre-money valuation. She projects the company will generate $500,000 in free cash flow in year one, growing 40% annually for five years, then 15% in perpetuity. Using a 25% discount rate (reflecting early-stage risk), she calculates: Year 1: $500,000 ÷ 1.25 = $400,000; Year 2: $700,000 ÷ 1.56 = $448,718, and so forth. Adding the terminal value (calculated using the Gordon Growth Model) and summing all discounted cash flows yields an intrinsic value of $8.2 million. This suggests the $10 million valuation may be slightly aggressive, prompting negotiations or further examination of growth assumptions.