Please elaborate on why the following statement is false: “For venture capital investment in the early stages of analysis, emphasis is placed on the discounted cash flow approach to valuation.” Any also, kindly tell me what valuation method would be appropriate on the above scenario.
Cash flows would be negative in early stages, so DCF won’t work. Can’t recall the appropriate valuation… perhaps Venture Cap method?
VC Pre and Post money evaluation method. Essentially a NVP calculation at equity level to work out how much the company is worth POST money then subtract your own investment to derive at PRE money valuation
The negative cash flow during the early stages, and the subsequent large Terminal Value is the very point of using the DCF method. I think Chi Paul was referring to the valuation multiples method where you cannot use a negative earnings figure as a basis for valuation. I do understand the Pre and Post Money valuation concept, and the above problem is not referring to that. The problem above was taken from one of the EOC questions of the CFAI volume 5 book and is essential for all of us to understand it inside and out. Thank you for your time.
PRE and POST are in relation to valuing shares in a VC deal. Generally speaking, VC projects have a low success rate. Relying on a DCF on a project that has a high chance of failure doesn’t seem prudent. I’m not sure if this is the answer you’re looking for, but the study guide doesn’t offer much detail on this item.
Nice try, but not exactly the response I was looking for. The problem simply states that VC investment DO NOT use DCF during the early stages. I was wondering (i) why?, and (ii) what does CFAI suggest investors use to value early-stage VCs? Thanks!
I assume you mean investment VC makes to early stage companies. Here is what I understand. (i) why?, -Forecasting cash flow for new companies are notoriously difficult and unreliable. and chances for failure high. and (ii) what does CFAI … VC Pre and Post method.
DCF is never used for VC investments in the early stages as the cash flow is not predictable and also because the firm does not have a historical record of cash flows which can be used to estimate fututre cash fows. The appropriate valuation for such investments is replacement cost method as it is easier to determine how much it would cost to replace the project.
Forum I stuff but may be a bit relevant. Hope that I do not confuse the matter even further. http://www.analystforum.com/phorums/read.php?11,1085863
Thanks for the inputs. I guess that pretty much answers it. The responses below made me a believer: (i) DCF cannot be used since cash flows are unreliable and difficult to forecast (ii) PRE and POST methodologies using the investor’s required rate of return In all the material of CFA I read, this section really made me drool. I even converted into an excel worksheet absolutely all examples for LBO, PE, VC, etc.
firms seeking venture capital investments are also typically in a “new business area”. Two new things here. 1. Firm itself has no history. 2. There are no industry precedents, either. So a. it is difficult to foretell how much cash flow is reasonable from the firm. b. additionally - how much that cash flow could be reasonably expected to grow. c. what kind of a discount rate may be applied to discount those cash flows down to arrive at a DCF estimate. too many variables…
Yes, this strengthens the rationale on the above conclusion. Thanks.
actually I was thinking more in terms of free cash flow models, not NPV/IRR calcs when I said negative cash flows would cause problems. But as cpk notes, the unreliability of future cash flows is what really makes it difficult.