Understanding Investors’ Required Return
In the previous article we discussed Discounted Cash Flow valuation methods. These well-known methods discount future cash generated by the company to understand its value today. The cash flows are discounted according to the risk of realization. Indeed, the higher the risk that these cash flows will materialize, the lower their value today.
However, the discount rate used has another interesting aspect that is important for both entrepreneurs and investors — the required return.
What does it mean- the required return?
The required return represents, for both parties, the company’s growth in value that needs to be achieved in order to justify the initial investment.
Usually, the concept of required return is associated with external investors, however it is important to remember that the entrepreneur is usually the most exposed investor in the venture. The entrepreneur, indeed, invests most of the time, energy and money on a single venture, and thus is not diversified.
How is it related to the discount rate?
The concept of required return and its connection to the discount rate of DCF methods has a great deal of importance in calculating and defending the valuation.
All the entrepreneur has to do is convincing the investor that the discount rate used is higher than the investor’s required return.
To explain this a bit better: if cash flow assumptions are properly done and believed as achievable by the investor, then it is just a matter of probability of achieving them. To account for this probability (also called uncertainty) we use a certain discount rate. Through this process, the price offered to the investor reflects a probability of reaching the forecasted cash flows. If the investor believes that the probability is higher than the one implied by the price, then the value calculated with his own estimate of probability will be higher than the price offered. In other terms, the value of the company as calculated by the investor will be higher than the price the entrepreneur proposed to the investor. If the value is larger than the price, the decision to buy is made.
Of course, in real transactions these probabilities are not visible, usually not even guessable. Multiple scenarios can happen and projections are usually not certain even if supported properly. For this reason, the estimation of these probabilities is much more difficult.
The investor needs to have a clear view of his required return. Especially venture capital investors need to see a certain growth opportunity and path in order to justify the investment to their limited partners.
It is our role as entrepreneurs to give the investors as much information as possible for them to have the best estimate of this probability and be confident that the investment they are making is worthy.