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May 25, 2016

Discounted Cash Flow (DCF) Analysis: How to Calculate Your Rates

Sam Lloyd

Article Cliff Notes

A quick rundown for SaaS marketing ideas using DCF to calculate a more accurate customer lifetime value.

A detailed analysis of the WACC and CAPM equations and how to apply them to your business or execute in your startup marketing strategy.

Ready to learn how to run discounted cash flow model? It’s imperative to recognize the value in applying discounts on future cash flow models when considering the long term value of a client.

This discounted cash flow analysis (DCF) can be applied to your business’s cash flow calculation by simply plugging in your own numbers or using our estimates or by using a discounted cash flow calculator.

In the following, we’ll lay out a case for rates around 10% for publicly held (Saas) firms and 15-20% for startups, gravitating higher the more risk the startup has on executing its vision.

Looking for cost of equity formula for your business? Discount factor formula? Trouble tying it all together? Read on for a comprehensive rundown on discounted cash flow analysis through the lens of SaaS companies.

 

What is the Discount Rate?  The WACC Needs to be the Same as the Discount Rate

Here at Klicker, your friendly neighborhood inbound lead generation agency we use DCF on the regular. Financial best practice is relatively constant on this point: every time a discount company spends capital they spend money, so they need to be thinking about what that capital costs in real terms. Capital can come from many places, the average of all these various sources is referred to as the Weighted Average Cost of Capital and is found using the WACC formula.

Most of the time the WACC is simply going to be debt averaged against equity (related: cost of equity calculator — a great free tool), although some companies have unique financial structuring and there are more than just a couple factors in play.

Let’s get into some of the actual cash discount rate formulas. Finding WACC simply means multiplying the cost of equity x % equity in your company’s capital structure and then adding to it the value of debt x the % of debt on the companies books. Debt interest is not taxable, so the total cost of debt can be reduced by whatever the applicable tax rate is (related: pre-tax cost of debt calculator). 

Here is the equation….

 

Ke = refers to the cost of equity, which is found using the Capital Asset Pricing Model (CAPM) detailed below.

Kd = The cost of debt refers to the average debt interest rate for a given company. To get the cost of debt you divide the discount by the market value of company debt since the value of company bonds go up and down. For our purposes, this is needlessly complicated, however, and going off the book value is sufficient. 

T = the corporate tax rate. This can generally be considered 35% (in the US) because it’s the same as the marginal tax rate.

Ve = the value of equity. The market cap of a company less cash and debt. For privately held companies this can be estimated using the last price round as a proxy.

Vd = the value of debt. As defined previously, the book value can be used as an estimate.

Breaking it Down For Startups

Equity is the most common vehicle for financing in the startup world, so for future cash flow determinations, it might be useful to make things simple and say that the WACC value equates to Ke, meaning the discount rate will equal Ke. 

Calculating the Cost of Equity — Using the CAPM Model

The Capital Asset Pricing Model (CAPM) is how we reach the value of Ke. Investors set their expectations on how their stocks will perform. If they think the stock value will go they might sell it further reducing its value or if they resolve that it will outperform estimates they might buy more driving prices up and eventually pushing Ke into equilibrium.

To find Ke the following formula should be used (CAPM)

 

 

Rf =  denotes the risk-free rate of return. A nice proxy to use for Rf are government bonds for a matching timeframe of investors planning involvement with a stock. The US government T-bill is a prime example, its turned up 1.7% annually, and 2.2% over a decade, so a 2% risk-free rate can be considered a decent proxy.

B (beta) = Reactivity to the (expected) stock return against the market return, the only way to reach this figure it to look for historical precedents. In mathematical terms, it’s B = Cov (Rs, Rm)/Var(Rm). A quick hack for this number is to look to similar public companies. Today’s average beta for Saas companies is generally hovering around 1.3.

Rm = refers to the rate returned from the market – i.e. what percentage investors think the market will return. For the last ten years, the stock market has returned about 8% annually on average. It’s not unreasonable to keep this as Rm. Obviously a lot of variables in play here, but let’s stick with these numbers for the sake of example.

For a Saas company here’s how this might look…

Ke = 2% + 1.3 (8% – 2%) = 9.8%  —  10% for a public SaaS company.

In terms of a private company or a start the up, risk is going to be higher, and Ke will hinge on the assumed market rate of return.

It should be noted that reality is volatile and each scenario is subject to its own set of variables — sometimes funding can be easily raised sometimes it can’t (for example). A good deal of situational decision making needs to be applied, but Cambridge Associates, who track well-known venture-funded firms, claims there is on average a 17.7 rate of return for investors.

So, going back to our equation, (if we accept the 17.7 proxy) one can assume for a private Saas company.

Ke = 2% + 1.3 (17.7% – 2%) = 22.4% — 20% for a private Saas company.

Conclusion

Looking at discounted cash flow analysis examples is a great way to wrap your head around the subject. Saas companies looking to use DCF to determine lifetime customer value should use the following rates as a benchmark:

  • 10% for publicly traded companies
  • 15% for privately held companies that are growing predictably
  • 20% for privately held companies that have not yet scaled

Could the argument be presented that SaaS startups shouldn’t use different discount rates than public SaaS companies, as their aim is to prove their value using the same economic measures? Yes, there is something to be said for that. But this analysis is uncharted waters to a degree, feel free to chime in or offer up an opinion below. 

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