valuation

It depends on how many years we are projecting. In a 5-years DCF, the terminal value (TV) would account for 70 – 80% of the business valuation, and in a 10-years DCF, about 50%.

Let’s take an example. Consider a firm that generates an after-tax operating profit of $100 million. With 25% return on capital (ROC), it reinvests 40% of its earnings back into the business, thereby generating an expected growth rate of 10% for the next 5 years:

Expected growth rate = 25% * 40% = 10%

After Year5, the growth rate is expected to drop to 5%, but ROC to stay at 10%. Terminal value is calculated as follows:

Expected operating income in Year6 = $100 million * (1.10)⁵ * (1.05) = $169.10 million

Expected reinvestment rate from Year5 = 5% / 25% = 20%

Terminal value in Year5

[$169.10 million * (1 – 0.2)] / (0.10 – 0.05) = $2,705.6 million

Present Value of firm

(44 / 1.10) + (48.4 / 1.10²) + (53.24 / 1.10³) + (58.56 / 1.10⁴) + (64.42 / 1.10⁵) + ($2,705.6/1.10⁵) = $1,900 million

Now,

$1,900 M / $2,705 M = 70.24%

You may also refer my article on Valuation: Asset Approach, Income Approach and Market Approach here.

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Pre-money and post-money are measures of valuing a company. Pre-money valuation refers to the company’s value before the investor makes an investment in the company and post-money valuation refers to the value of the company after the fund is infused into the company. Let’s take an example to understand the concept.

Let’s assume that an Investor agrees to invest $300,000 in a start-up which is valued at $1 million. The following table explains how the ownership changes in both the situation for the same amount of investment. Let’s ignore the option pool for now to keep it simple.

Individual	Pre-Money Valuation		Post-Money Valuation
Individual	Value	Ownership	Value	Ownership
Entrepreneur	1,000,000	77%	700,000	70%
Investor	300,000	23%	300,000	30%
Total	1,300,000	100%	1,000,000	100%

As we can see above, the ownership percentage depends on the value placed on the company – pre-money or post-money. In pre-money valuation, the company is valued at $1 million before the investment. So, after the investor’s funding, the total value of the company increases, thereby decreasing the investor’s share of ownership. In post-money valuation, the company is valued at $1 million after the investment. So, the investor share increases by 7%. This percentage difference looks small, but can reflect millions when the company goes public.

Investors like Venture Capitalists and Angel Investors generally use the pre-money valuation to determine the “ask” – percentage ownership in the company against the funding – and is calculated on a fully diluted basis. Usually, a fund raising company receives a series of funds (Series A, Series B, Series C, etc.) so that investors minimize the risk of their investment. It’s also a way to motivate the Entrepreneur to achieve the agreed upon milestones. The pre-money and post-money concepts apply to each subsequent series of funding.

Determining pre-money and post-money valuation through formula

Post-money valuation = New funding x (post investment shares outstanding /
shares issued for new investment)

Pre-money valuation = Post-money valuation – new funding

For example, Company A owns 100% stake with 1,000 shares. Investor A infuses $1 million capital into the company against 200 shares (20% ownership), the post-money valuation will be:

$1,000,000 x (1,200/200) = $6 million

Pre-money valuation = $6 million – $1 million = $5 million

The same approach to calculation applies to subsequent series of funding as well.

You may also refer my article on Valuation: Asset Approach, Income Approach and Market Approach here.

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What percentage of valuation is usually in the terminal value?

Startup Valuation: Pre-money and Post-money