Using DCF analysis in the midst of great uncertainty

In an article adapted from their Wiley book, Valuation: Measuring and Managing the Value of Companies, five McKinzie consultants stitch together a cogent framework for applying discounted cash flow (DCF) and scenario planning to internet companies, rampant uncertainty and all. Theirs is an approach to be considered for other early stage technology companies and IP valuations.

For the most part, the authors are talking to investors and to company owners. They disavow shorthand valuation techniques (revenue multiples, etc.) in any case where rapid revenue growth is accompanied by little or no profits (where they cleverly describe it as “DCF analysis when there is no CF to D”), and they recognize the uncertainty in picking winners from the ones who will “toil away amid obscurity and worthless options.”

The authors instruct valuators to “start from the future” when forecasting performance, suggesting analysts think about what the industry and company will look like once they evolve from the current unstable situation to a more sustainable one, taking into account metrics such as the “ultimate penetration rate, average revenue per customer, and sustainable gross margins.”

Here’s the fun. The authors originally wrote the book in 2000, and they look at Amazon.com as an example with which to apply their techniques, running four separate scenarios.  It’s been 12 years now, and readers have the luxury of back-checking the process.