Step 3: Determine the discount factor
As explained earlier in the example where I said I will give you €1,000 (disclaimer: I am not planning to honor that promise ;) ), the value of money deteriorates over time: future money is worth less today. So how do you determine today’s value of the future cash flows that we have calculated in step two?
You do this with the help of the discount factor (see the blue lined part in the valuation example above), which you calculate based on the WACC, the Weighted Average Cost of Capital. The calculation of the WACC might be even more difficult than remembering what the abbreviation stands for. That is why won’t do a deep-dive into the WACC right now.
In essence the WACC is a percentage and is (in the context of valuating a startup) a way to define the risk an investor is taking when he/she invests in a firm. The higher the WACC percentage, the higher the risk and the lower the valuation of your firm. As investing in startups is risky to begin with, it is not strange to see high WACC percentages for such firms.
So, what do you need the WACC for anyway? With the WACC you calculate the discount factor. The discount factor determines the present value of your future cash flows, in other words: your valuation! The discount factor is calculated using the formula below, per year:
Discount factor = 1 / (1 + WACC %) ^ number of time period
The number of the time period is in this case the specific year of your forecast. In our valuation example above 2017 is time period number one, 2018 is number two, and so on. In the blue-bordered section you will see that when the WACC is 15% (using the formula above), the discount factor is 0.87 in 2017 and 0.50 in 2021.
Observe how the discount factor decreases over time. This clearly shows the essence of the decrease in monetary value over time. The further away your future earnings are generated, the less they are worth today.
Moreover, given the discount factor formula above, the higher the WACC %, the lower the discount factor, which in turn means a lower monetary value of the cash flows. This illustrates how a higher risk of investing (a higher WACC) also reduces the value of the cash flows and thereby the valuation.