One common issue I run into when valuing companies with a DCF is when companies have negative unlevered free cash flows for the first few years of the projected period. Traditionally, you would discount all the forecasted years at some WACC with the appropriate discount factor based on the timeline for that respective cash flow. However, discounting the unlevered free cash flows that are negative seems like it would result in a DCF valuation that overvalues the company. What is the reasoning for discounting a cash flow that is negative and is there any alternatives to this?
For example, a company has projected unlevered free cash flows in years 1 – 5 of ($12.0), ($5.0), $5.0, $10.0, and $15.0, which leads to discounted (20.0% WACC) cash flows of ($10.0), ($3.5), $2.9, $4.8, and $6.0.
Empirically you wouldn’t pay ($10.0) dollars now to get back ($12.0) dollars 1 year from now. This is obviously a limitation of a traditional DCF model, but I want to better understand recommendations from thought leaders in this area.
Isn't losing money in the future better than losing it in the present? Would you rather realize a $10 loss today, or realize a $10 loss next year? It's the same logic as wanting $10 today vs $10 in the future, just reversed. If the underlying assumption is that money is less valuable in the future than it is today, you would rather lose it in the future than today.
Negative cash is not workaround problem that “conveniently” lends itself to DCF math. It a business reality - the business will not function without cash. Factor in a cash raise via equity issuance or debt raise so that you are not cash negative. Yes, it will hurt returns via dilution or interest expense/leverage/covenants respectively, but that’s the realistic way to do it.
Typically I have people model a revolving credit facility to avoid negative cash balance
Hey, may I know what rate should be used for the revolver? I know it is SOFR + rate, but not sure what rate is to be used (most of my guides have the LIBOR rate)
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