
Intrinsic Value of a SaaS Business: A 20 Year DCF - pstrazzulla
https://www.selectsoftwarereviews.com/blog/2018/12/31/the-intrinsic-value-of-a-saas-business-a-20-year-dcf
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aaavl2821
The DCF is an alluring but dangerous way to value a company. It is alluring
because it seems like a much more logical, first-principles way of valuing a
company compared to slapping a market-based revenue multiple on a company's
projected sales. It is alluring because it is precise.

It is dangerous because it is not accurate. DCFs are very sensitive to
assumptions, and confidence intervals for most assumptions are very wide. Two
DCF models with credible, but different assumptions can yield hugely different
valuations.

DCFs are also dangerous because stocks are not valued solely based on
fundamental cash flows. In startups especially, if you do a typical DCF with
conservative assumptions, you will miss outlier returns when an acquirer's
thesis hinges upon very aggressive assumptions or synergies that a DCF
wouldn't capture. This happens all the time in biotech.

It is not true that DCFs are independent of how the market values things. Many
key inputs into the DCF, especially the discount rate and terminal value, are
calculated in part based on how the market values things.

In practice, investment bankers and investors use several different
methodologies, all somewhat flawed, to triangulate around a valuation. Often
the DCF yields the highest valuation of these methodologies.

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pstrazzulla
You're very spot on! DCFs are just one more way to triangulate. However, I
think they can be very telling around where value drivers are, what what
assumptions have to be in order to get to certain outcomes. It's definitely
more useful than "SaaS companies trade at 7x forward revenues" as a DCF can
help you capture the idiosyncrasies of your investment.

~~~
aaavl2821
I agree that DCFs are valuable in driving into assumptions. Taking a few
"market" DCFs and seeing for which assumptions your view diverges from market
is very helpful

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justchilly
The assumptions in your screen capture are dramatically more aggressive than
any company in history. E.g. You are showing 60% yoy revenue growth 10 years
in. For comparison: Google in year 10: 31%. Amazon in year 10: 23%. Dropbox in
year 10: 27%. If these kinds of growth rates were possible, there would likely
be much higher discount rates to go with them. Lots of investors do long term
DCFs like this (and almost all update 5-year models on a rolling
basis).They're just not as useful as a shorter term model given lack of
visibility that far into the future and likelyhood of having to return funds
well before then.

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aytekin
Yes, once you scale really big it is hard to keep a high growth rate. But if
you have been always growing at 50% YoY, it is possible to keep that rate even
at year 12. This is pretty common amount bootstrappers. I am speaking from my
own experience at the company I founded: JotForm’s last 7 years were at 50%.

Ahrefs recently announced a similar growth rate: [https://medium.com/swlh/how-
we-achieve-65-yoy-growth-by-igno...](https://medium.com/swlh/how-we-
achieve-65-yoy-growth-by-ignoring-conventional-startup-advice-24a3eef619c1)

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ttul
I wanted to know the long-term value of my recurring revenue company. Being a
programmer at heart, I wrote a python script that tested out 100,000 random
scenarios of customer churn over the next 50 years. This gave me a histogram
of future cash flows from the business, allowing me to state with some level
of certainty what the range of future cash flow was likely to be.

I was really surprised at how valuable the company is when analyzed in this
manner. And there’s no bullshit. You assume a churn rate and randomly try it
out over thousands of scenarios.

~~~
pstrazzulla
Please share the script!

So essentially it's taking the average churn for a given customer, and running
a monte carlo simulation to see what the expected scenario is?

Turns out, low churn and high margin companies are worth a ton! Especially
with low interest rates and a public equities market that shouldn't return
more than 4% real over the next few decades. Not a lot of other places to put
your capital.

~~~
stcredzero
_Turns out, low churn and high margin companies are worth a ton! Especially
with low interest rates and a public equities market that shouldn 't return
more than 4% real over the next few decades. Not a lot of other places to put
your capital._

What margins qualify as "high?" I have a SaaS offering I'm working on, and I
was going to charge as a multiple of my compute and network costs. Is 85.7%
"high" for SaaS? Or is that meh?

~~~
pstrazzulla
85.7% is very high, that'd be a great gross margin (revenues - variable costs,
such as compute/network costs).

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vbhartia
great write up. always been curious about this... how do you value growth...
especially as Uber / Lyft IPO and face slowing growth.

What basis do you use to get the discount rate of a SaaS company? This seems
fairly arbitrary and is a key part to valuing a company

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clairity
> "What basis do you use to get the discount rate of a SaaS company? This
> seems fairly arbitrary and is a key part to valuing a company"

this is one of the things you learn in an MBA program. you'd generally use
multiple methods to triangulate a rational estimate. for example, you'd look
at industry comparables and estimate a beta to plug into CAPM (as sibling
commenter touches on). you can also do full financial projections (5-7 years
out) based on expected performance, do DCF, and monte carlo that to back out a
discount rate. you can also do a comparative ratio analysis
([https://www.investopedia.com/terms/r/ratioanalysis.asp](https://www.investopedia.com/terms/r/ratioanalysis.asp))
on profitability, cash flow, asset efficiency, turnover, and the like.

from my (limited) experience, startup valuations seem to be most sensitive to
growth rate and the discount rate, so modelers spend a lot of time estimating
these factors.

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pstrazzulla
This guy is basically the god of the DCF:
[http://aswathdamodaran.blogspot.com/search?q=dcf](http://aswathdamodaran.blogspot.com/search?q=dcf)

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clairity
ha, yes, we used damodaran's book in my corporate valuation class!

i forgot to mention that you can also employ an option pricing model, like
black-scholes or the binomial model (in simpler cases), in cases with multiple
classes of equities, wherein you can back out a valuation (and subsequently, a
discount rate) based what the various VCs involved are expecting.

~~~
pstrazzulla
Very true. Especially since the equity value of a startup basically looks like
an out of the money call option where you're paying a small amount now for a
potential large payoff of our money (but high chance of $0 outcome). Also,
more volatility will increase the value of this option (whether it's founder
or market volatility - aka Travis from Uber or Cypto or Cannabis).

