Valuation vs. Returns

Hi all

Potentially rookie question but here goes...

Imagine I have a company in which I want to make a $10m investment. Let's assume based on DCF that I value the company at $90m pre-money. Free cash flow for the company is as follows:

Year 1: $10m
Year 2: $30m
Year 3: $50m
Year 4: $80m (my exit year)

Let's assume the company pays no dividends but let's assume I get a 5x FCF multiple on exit in Year 4.

Is it right to say that when I value the company, I should include undistributed interim free cash flows in Years 1 to 4 in the DCF analysis even if the company retains all of that cash to fund future growth, but when I calculate my expected returns, the cash flow profile I should use for my IRR is the below:

Year 0: ($10m)
Year 1: $0m
Year 2: $0m
Year 3: $0m
Year 4: $400m ($80m * 5x multiple) * 10% (my post-money stake) = $40m

So essentially I use different cash flows for my investment valuation / returns vs. the actual company valuation?

My logic is that the first approach values the potential cash flows generated by the business available to equity holders (assuming it's FCFE) and is therefore theoretically the value I should place on that opportunity as an equity investor, whereas the second approach estimates the actual cash flow that I expect to receive as an investor?

Thanks for any help

P.S. A secondary question if you're not bored yet... In the first approach, is the idea that the company can grow at the same pace even if it does not re-invest the interim cash flows? I.e. it could theoretically sit on that pile of cash and not need to draw upon it? I know for example that CapEx and changes in working capital are adjusted for in calculating FCF but in reality is that the assumption? The reason I ask is for my DCF, I am essentially saying that I could in theory withdraw that full amount of cash flow from the business in, say, Year 2, with absolutely no impact on my Year 3 cash flows - but that seems an unrealistic assumption? Thanks

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Or maybe the following users have something to say: PEjunkie brian_1 mvashon77

Fingers crossed that one of those helps you.

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I'll bite.

You're mixing up cash flow metrics, which result in comparing a NPV (or DCF) analysis of the company inconsistent with your own investment IRR calculation. If the timing of these cash flows are on a consistent basis, then your NPV should yield a $0 value when you plug in your own investment IRR as the discount rate. Brush up on the relationship between IRR and discount rate -- using the former in your NPV analysis should result in you being "indifferent" towards the investment, i.e., NPV of $0.

Where your "disconnect" arises is from the FCF of the company over time. Let's just assume there is no debt on the business, so levered FCF and unlevered FCF are the same. If the company is not distributing that cash to investors over time, then its cash balance is growing. Just because the company may "earmark" that excess cash for future investments, its cash that is still owed to the equity holders and should be part of their exit proceeds.

The attached image outlines three situations from both your individual investment perspective and the valuation of the company. 1) no interim cash flows included (i.e., returns based on buy-in and exit prices only). 2) interim cash flows distributed as they come in (as an individual you would get your pro rata share of 10%). 3) interim cash flows accrue to cash balance (same pro rata assumption as #2).

Edit: [here is a link to the PDF]

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Valuation vs. Returns

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