28/04/2024, 15:55 How to calculate the Discount Rate to use in a Discounted Cash Flow (DCF) Analysis - For Entrepreneurs

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How to calculate the Discount Rate to use in a

Discounted Cash Flow (DCF) Analysis

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by David Skok(https://www.forentrepreneurs.com/author/david/) 7 (https://www.forentrepreneurs.com/discount-rate-for-dcf/#comments)

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We look at how to compute the right discount rate to use in a Discounted Cash Flow (DCF) analysis. This post is a supplement to a blog post titled “What’s
your TRUE customer lifetime value (LTV)? – DCF provides the answer (/ltv/)“.

My thanks to my partner Stan Reiss (http://www.matrixpartners.com/team/stan_reiss/), who co-authored this piece with me, providing all the expert math
help.

In that blog post, we discuss why it is valuable to apply discounts to future cash flows when calculating the lifetime value of a customer (LTV). This
discounted cash flow (DCF) analysis requires that the reader supply a discount rate. In the blog post, we suggest using discount values of around 10% for
public SaaS companies, and around 15-20% for earlier stage startups, leaning towards a higher value, the more risk there is to the startup being able to
execute on it’s plan going forward.

The Discount Rate should be the company’s WACC

All financial theory is consistent here: every time managers spend money they use capital, so they should be thinking about what that capital costs the
company. There can be many sources of capital, and the weighted average of those sources is called WACC (Weighted Average Cost of Capital). For most
companies it’s just a weighted average of debt and equity, but some could have weird preferred structures etc so it could be more than just two
components.

To calculate WACC, one multiples the cost of equity by the % of equity in the company’s capital structure, and adds to it the cost of debt multiplied by the %
of debt on the company’s structure. Because interest in debt is a pre-tax expense, the cost of debt is reduced by the tax rate (it’s effectively tax deductible).

The formula is

Ke = the cost of equity. This comes from the Capital Asset Pricing Model (CAPM), described below.

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28/04/2024, 15:55 How to calculate the Discount Rate to use in a Discounted Cash Flow (DCF) Analysis - For Entrepreneurs
Kd = cost of debt. This is the average interest rate on the company’s debt. To be completely correct, it’s the coupon divided by the market value of debt,
since the value of company bonds fluctuates, but generally this is too complicated for the exercise at hand and, unless the company is in distress, just
looking at the book value is close enough. (https://matrix

T = corporate tax rate. The right number to use is the marginal tax rate since you’re trying to make a marginal decision, and that’s typically 35% in the US.

Ve = value of equity. Company market cap less cash plus debt. For a private company, best estimate – probably based on last round price.

Vd = value of debt. As described before, the proxy is book value.

Simplifying this for Startups

For most startups, equity is the primary method of financing, so it may be helpful to simplify things and state that WACC equals Ke (the cost of equity),
which effectively also means that the Discount Rate should be equal to Ke.

Computing the Cost of Equity – The Capital Asset Pricing Model (CAPM)
The cost of equity, Ke, comes from the CAPM. What investors expect to earn on their investment in the stock. If they conclude they won’t get this return
they’ll sell the stock and the price will go down, if they conclude they’ll get more than this return additional investors will buy the stock and the price will go
up, eventually driving the return to Ke in equilibrium.

The basic CAPM formula for Ke is

Rf = Risk free rate of return. A good proxy is a US government bond of a duration that’s commensurate with the time frame an investor would think of
when owning the stock. The 5 year T-bill is a good proxy. Today the 5 year T-bill yields 1.7%, the 10 year 2.2%, so a 2% risk free rate is a good proxy.
B (Beta) = Sensitivity of the expected stock return to the market return. Have to use history to estimate. Mathematically it’s the covariance of the
historical return of this particular stock and the market divided by the variance of the market. So B = Cov (Rs, Rm)/Var(Rm). The best way of getting
at this is to look at the beta of similar public stocks. For public SaaS companies, the beta today seems to be about 1.3.
Rm = Market rate of return – what the investors expect the market to return. The public markets have returned around 8% per year over the last
decade, and one would think that that’s a reasonable rate expected by investors. There could be different opinions (for example the 5 year rate of
return is a lot higher). If a company is private, one would expect a much higher rate of return.
Plugging all this in for a SaaS company, one would get

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

For a private, or higher risk company, Ke will depend on the assumption on Rm (the market rate of return). Reality is this is highly volatile and situation
specific – sometimes one can raise cheap money and sometimes one can not. While a lot of situational judgment should be applied, Cambridge
Associates, which tracks the stronger venture firms, claims a 30 year venture return of 17.7%, and that’s probably the best proxy.

So for a private SaaS company one could assume

Ke = 2% + 1.3 (17.7% – 2%) = 22.4% ~ 20% would be a good estimate to use

For reference our Beta calculation came from averaging Google Finance Betas for a selection of public SaaS companies:

Salesforce.com – 1.33
Workday – 1.53
ServiceNow – 1.11
Netsuite – 1.5
LogMeIn – .96
Liveperson – 1.35
Demand ware – 1.31.
The newer SaaS public cos (ZEN, HUBS, MKTO) haven’t been public long enough to calculate a good Beta.

Conclusion
For SaaS companies using DCF to calculate a more accurate customer lifetime value (LTV), we suggest using the following discount rates:

10% for public companies

15% for private companies that are scaling predictably (say above $10m in ARR, and growing greater than 40% year on year)
20% for private companies that have not yet reached scale and predictable growth
Is there an argument to be made that startup SaaS companies shouldn’t be using a different discount rate to public SaaS companies, as their goal is to
show that they have the needed unit economics to become a public company? Yes, there probably is. We are charting new territory with this analysis, so it
will be interesting to hear readers’ feedback on this question.

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U2GT − ⚑
8 years ago

Great summary and reminder for everyone. The one issue with this approach is it is based on
historical data. Beta calcs are no always statistically significant and can vary signficiantly over
different periods of time, etc. There are other data points to consider. Another source for Ke is the
returns implied by VC/PE models which look forward. I see many VC/PE models for tech deals that
aim for a 3x return within approximately 4 years which is a 31.6% CAGR. Based on these models,
20% to 30% is a more reasonable Ke range for a private company DCF (the VC/PEs are discounting
at a higher rate than the historical studies above). The WACC can also be determined from LBOs
and comparable transactions without relying on historical statistical data. The leverage portion of
the WACC equation comes from the debt used in a particular deal, the debt rate is a market rate for
the industry and and leverage on the deal, and Ke is the forward return that the VC/PE is requiring
(what they modeled based on exit assumptions). For exampe, if a large application software
company goes private, all the metrics in the model are a comp for the WACC equation that can be
used for other application software companies. Of course this data is not as readily available to the
public like the data discussed above, but it is more accurate because it measures the expected
return (forward looking) for the particular transaction and industry. If a PE firm takes a company
private and assumes a 25% return on deal with 70% leverage, then the WAAC is easily calculated
without any regression analyses, and can be used as a practical, real-world data point for other
deals. In other words, the best "market" WACC data is embedded in all VC and PE models.

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David Skok Mod > U2GT − ⚑
8 years ago

Thanks for your comment - this is very helpful. Do you have a good guess as to what the
WACC would be on that PE deal that you mentioned looking for a 25% rate of return, with
70% leverage?

0 0 Reply ⥅

U2GT > David Skok − ⚑

8 years ago

Hi David. Your SaaS blog is superb! 25% is actually too aggressive and not a
good example. 30% to 40% in equity is more market for industrial companies
and 40 to 60% for technology (because debt limits on EBITDA are about the
same for both, but there is a big difference in valuation multiples, which reflects
the higher growth in technology). Here is a practical software example: a
company with $100M of revenue (growing 20%) with $20M of EBITDA will likely
realize a value in the 12x to 15x EBITDA range ($240M to $300M). The first
practical constraint is how much debt can be used in the buyout. Generally
speaking 6x-7x is aggressive, but let’s assume 6x is possible in this example. 6 x
$20M = $120M. So the debt market has dictated the leverage ratio of 44.4% for
the WACC formula above (no need to review comps). Average rate on the debt
will be about 6.5% and let’s assume the tax rate is 40%. If the company sells for
$270M (13.5x EBITDA), then equity value = $150M and debt value = $120M. The
VC/PE has certain exit values in their model that imply an equity return. In my
experience the investor is targeting a 25% to 35% return over 3 to 5 years, but
this is not an input to the model, but an output from their estimate of risk, the
exit time and value, and the price they bid to win the deal. Almost all the models
I see result in a 25% to 35% equity return target, but investors may
underwrite to higher or lower rates depending on the situation. At closing, the
implied WACC for this deal = [($150M/($150M+$120M)] x 30%] +
[$120M/($150M+$120M) x 6.5% x (1 -40%)] = 16.7% + 1.7% = 18.4%. Note that if
the
leverage ratio changes, the WACC won’t change much because the investor’s
expected equity rate of return will decline with less leverage (less financial
risk) and it will increase with more leverage. Each closed VC/PE deal has a
model with the ‘expected’ return. Again, I admit this information is not
readily available, but it’s out there. Based on my experience expected Ke for a VC
in a high growth technology investment (e.g., a Series B round) is 25 to 35%, but
there is no leverage on these companies. For larger companies
like in the example above, Ke is also about 25-35% but it’s a leveraged return
(i ld b l ih l ) S h CC f h l dS i
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28/04/2024, 15:55 How to calculate the Discount Rate to use in a Discounted Cash Flow (DCF) Analysis - For Entrepreneurs
(it would be lower without leverage). So the WACC for the unleveraged Series B
round might be 30%, but the WACC for the larger PE transaction is 18.4%. This
makes sense because the unleveraged Series B has more business risk, and
(https://matrix
less financial risk. Another way to describe both of these scenarios is that the
investor is expecting a “cash on cash” return of 3x within just under 4 years.
If it’s an early stage company and unleveraged deal, then they return 3x
their money or a 30% unleveraged IRR, and if it’s a larger company with leverage,
they still get 3x their money over the same period (30% leveraged IRR). I see
aggressive investors underwriting as low as 2x “cash on cash” and disciplined
investors targeting 4x “cash on cash.” I hope this adds a practical perspective to
the excellent theoretical explanation above. Looking forward to your future
posts.

1 0 Reply ⥅

David Skok Mod > U2GT − ⚑

8 years ago

Michael, many thanks for taking the time to write such a thorough
explanation. This is really helpful, and provided a new insight on how to
think about this. Much appreciated!

0 0 Reply ⥅

SM Sean McHugh − ⚑
4 years ago

Looking to do a lump sum buyout on a pension liability (that we withdrew from a few years back).
We still have 15 years of payments remaining on the liability. The pension is in critical status. What
would be an appropriate discount rate in this case.They initially offered a discount rate of 3.25%.
We got them up to 5.0%.

0 0 Reply ⥅

A
Atro Milambo − ⚑
4 years ago

What are the discount factor used by organization and what are the differences of discount factor
used?

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David Skok Mod > Atro Milambo − ⚑
4 years ago

The answer varies a lot depending on the risk levels of that company, and how mature it
is. Numbers might vary from as low as 7% in a highly mature public company, to as high
as 30% in a high risk startup. Because of this wide variance, if you wish to benchmark
your LTV against other SaaS (recurring revenue) companies, I recommend simply using a
discount factor of 10%. This number is far too low for a startup, and more appropriate for
a public company. But it at least allows everyone to use a standardized value when
computing LTV.
I hope that helps.

0 0 Reply ⥅

A
Atro Milambo > David Skok
− ⚑
4 years ago

Thanks for the clarification

0 0 Reply ⥅

AS
Aditya Shah − ⚑
4 years ago

How do I calculate the Market Value based on the DCF? We are a startup, hence took the DCF % as
20%.

0 0 Reply ⥅

David Skok Mod > Aditya Shah

− ⚑
4 years ago

Can you tell me at a higher level than this what you are trying to achieve? I think I may be
able to simplify your life a lot, as you may not need to be thinking about DCF or Cost of
Capital if you are in the earlier stages of startup existence (i.e. below about $15m in ARR).

1 0 Reply ⥅

C
Chris − ⚑
5 years ago

What discount Value would you use for a privet company that has not debts (we were bankrolled by
the owner who is looking to sell to Key employees.)
Would we just go with the cost of inflation?
Thank you.

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0 0 Reply ⥅

David Skok Mod > Chris

− ⚑
(https://matrix
5 years ago

I would just use 10%, as that way everyone using this formula will end up with a
standardized result. It is likely too low for a private company, but is helpful because of
being a single number for all using it.
Best, David

0 0 Reply ⥅

S
Sumit − ⚑
5 years ago

If the free cash flow is net of debt servicing i.e. Interest + Principal, wouldn't it be correct to use
cost of equity for discounting which is computed by using un-levered Beta. Unlevered Beta = Beta
(levered)/[1+(1-t)*D/E]

0 0 Reply ⥅

David Skok Mod > Sumit − ⚑

5 years ago

This is the universally understood way to compute WACC, but I should state that it really
is unimportant to get the nth degree of accuracy for the purposes of SaaS metrics. I’d
recommend using a discount rate of 10% so that all companies using this formula to
compute LTV are based on the same discount rate.

3 1 Reply ⥅

UdiDahan − ⚑
6 years ago

What values would you use for a bootstrapped/customer-funded company, assuming the only debt
was in the form of lines of credit or other bank loans?

0 0 Reply ⥅

David Skok Mod > UdiDahan

− ⚑
6 years ago

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Udi, for the purposes of calculating your LTV, I would suggest using a 10% discount rate. It
is definitely not the rate that you should use for your business calculations, but for
comparison with other SaaS companies, I think we need a standardized discount rate, and
10% is a good rough starting point. Best, David

0 0 Reply ⥅

UdiDahan > David Skok − ⚑

6 years ago

I'm not sure I understand that logic, as it would blur the distinction between
capital efficient and wasteful companies. Why would that be desirable for the
industry?

0 0 Reply ⥅

TruthNLogic − ⚑
6 years ago

In the private company discount rate, you are not accounting for the fact that the return for venture
capital firms already is based on higher beta firms. Applying a beta to a return from higher beta
stocks effectively double counts the industry risk. A better method is to account for the difference
as an alpha factor that is added on to the return for the broader market. In you example, that would
be (17.7% - 8%) reflects a size premium of 9.7%. Adding the 9.7% to the return for public SaaS
company of 9.8% derives a required return of 19.5%, not 22.4%. This is based on the expanded
CAPM formula K = Rf + Beta x (Rm - Rf) + alpha. The alpha represents returns not identified in the
basic equation, such as size, financial distress, etc.

0 0 Reply ⥅

David Skok Mod > TruthNLogic

− ⚑
6 years ago

Many thanks for contributing this insight.

David Skok
Matrix Partners
*Blog*: ForEntrepreneurs.com <http: forentrepreneurs.com=""/>

*E*: dskok@matrixpartners.com
*T*: +1-617494-1223
*A*: 101 Main Street, 17th Floor, Cambridge, MA 02142
*Twitter*: @BostonVC <https: twitter.com="" bostonvc=""/>

0 0 Reply ⥅

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Wojtek Łuczaj − ⚑
6 years ago

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