Investing is the process of placing money at risk to profit from its return in the future.
IPOs are a form of investment. They represent an investment in a “company that has not yet released any earnings and is untried and unpredictable. As such, they must be evaluated by their potential for returns; one standard method is using discounted cash flow valuation (others include comparative analysis and market comparison).
Discounted cash flow (DCF) valuation is based on projecting all of a firm’s future net cash flows, then discounting them to present value with a rate that reflects the time value of money and a company’s cost of capital (i.e., the weighted average cost of its debt and equity).
This article will discuss the discounting assumptions in DCF valuation, compare them to other methods, and conclude with a discussion on why companies choose to use discounted cash flow valuation for IPO valuations.
The Discount Rate: Required Return on Equity Capital vs Cost of Capital
The actual rate at which investors expect to be compensated is called the ‘required return’ or simply the required rate of return. The required return is an outcome that results from investment risk—it represents an investor’s compensation for taking on additional risk over what is considered safe by most investors. They look at the risk of an investment and the time frame over which they expect to earn a return.
In DCF valuation, the discount rate is calculated from the weighted average cost of equity capital and debt multiplied by an adjustment factor that reflects how risky future cash flows are compared to existing assets (a ‘beta’ value). This adjustment factor is called a firm’s asset beta. If a company currently has no debt or equity capital in its capital structure, it must assume one before calculating its discount rate.
To make this simplification, it can use either the market risk premium (ARMP) or the book beta from its accounting statements. The ARMP is a percentage of an asset’s return above the market. At the same time, the book beta measures how much risk investors perceive to be present in investing in that company versus the overall stock market.
Investors are compensated for taking on additional risk because assets can lose value during periods of negative growth, and there is little to no cash flow generation. Investors usually expect to recover any losses they incur when lending money at some point later down the road after overcoming these stormy years, so it makes sense that these expected gains get discounted into today’s prices based upon future expectations.
This article will focus on required returns instead of the cost of capital (which is also included in discounted cash flow valuation). The required rate of return provides an investor with a clearer picture of how willing they should be to invest based on their level of risk tolerance.
The Time Value of Money
The time value of money refers to the idea that people think differently about money over time. A dollar today has more value than a dollar tomorrow. Therefore investors expect to be compensated for this difference through higher returns because they are taking on additional risk by holding onto their capital longer before recovering any potential losses. The rate at which someone calculates these future expected gains into today’s prices depends significantly upon how long it will take them to realize those gains-the shorter the time frame, the lower the rate of return (r) someone is willing to accept.
Investors will demand more money for holding onto their capital for more extended periods because they must be compensated for both risk and the time value of money. Additional risk results in a higher required rate of return, while the time value of money contributes to a lower discount factor.
The Role That Debt Capital Plays in DCF
Discounted cash flow valuation models provide managers with a financial picture of how much equity and debt capital should be raised to maximize shareholder wealth. The difference between what a company can afford versus what it needs becomes clear when economists convert future expected cash flows into discounted present values using the WACC that considers these resources being used for what they were intended.