DCF for Negative Cash Flow: Valuing Growth Companies

Imagine trying to figure out the real value of a growing sapling. You wouldn’t just look at the tiny amount of fruit it might produce right now, would you? You’d think about its potential, how big and strong it could become, and the abundant fruit it might bear in the years to come. That’s similar to how we value companies, especially those investing heavily for future growth. One common way to do this is called Discounted Free Cash Flow, or DCF, valuation.

Think of free cash flow as the money a company has left over after paying for everything it needs to run its day-to-day operations and make necessary investments. It’s the cash available to be distributed to its investors. The standard DCF approach is like estimating the fruit harvest from our sapling year after year and then figuring out what all that future fruit is worth today. We do this by ‘discounting’ those future harvests back to the present because money today is worth more than the same amount of money in the future – a concept often called the time value of money.

However, what happens when our young sapling requires a lot of initial investment? Perhaps we need to buy special fertilizer, build a protective fence, and hire extra help to nurture it. In the early years, the cost might outweigh the small amount of fruit it produces. This is analogous to a company aggressively expanding and investing. They might be spending a lot of money upfront on things like building new factories, developing groundbreaking technologies, or expanding into new markets. During this phase, their free cash flow might actually be negative. They are spending more cash than they are generating.

Now, if we blindly applied the standard DCF approach, which relies on discounting positive future cash flows, we might get a misleadingly low valuation for this company. It would be like concluding our sapling is worthless because it’s costing us money now and isn’t producing much fruit yet. We need to adapt our approach to account for this period of negative free cash flow driven by strategic investment.

One key adaptation is to extend our forecast period. Instead of just looking a few years into the future, we need to project much further out, until we reasonably expect the company’s investments to pay off and free cash flow to turn positive and become sustainably positive. Think of it as waiting until our sapling matures and starts yielding a bountiful harvest. We need to project those future harvests, even if they are many years down the line.

Another crucial aspect is the terminal value. This represents the value of all cash flows beyond our explicit forecast period. In a standard DCF, the terminal value is often calculated based on the assumption of stable, positive growth in free cash flow. When dealing with near-term negative cash flows, the terminal value becomes even more important. It essentially captures the long-term value creation that is expected to arise from those initial investments. We need to ensure our terminal value calculation realistically reflects the potential for significant future cash flow generation after the expansion phase.

Furthermore, consider scenario analysis. Because we are projecting further into the future and relying on a turnaround from negative to positive cash flow, there is more uncertainty involved. It’s wise to consider different scenarios: a best-case scenario where the investments are wildly successful, a worst-case scenario where they fail to deliver the expected returns, and a most-likely scenario. This gives us a range of potential values and helps us understand the risks and opportunities associated with the company’s growth strategy. This is like considering different weather patterns for our sapling – ideal conditions, drought, or typical weather – and how each might affect its future fruit production.

Finally, it is absolutely vital to thoroughly understand why the company is forecasting negative free cash flow. Is it truly due to aggressive but strategic investments for future growth? Or are there underlying problems with the business model or operational efficiency masked by the expansion narrative? We need to dig deep into the company’s plans, assess the credibility of their growth projections, and evaluate the likelihood of their investments actually generating positive returns in the future. Just as we would inspect the sapling’s roots and soil to ensure it’s healthy and has the foundation for future growth, we need to scrutinize the company’s fundamentals to ensure the negative cash flow is a temporary phase in a journey towards long-term value creation.

By extending the forecast period, carefully considering the terminal value, employing scenario analysis, and thoroughly understanding the drivers of negative free cash flow, we can adapt the standard DCF approach to more accurately value companies that are currently investing for a brighter, more profitable future, even if their present cash flow picture looks a bit bleak.