What is the most effective way to determine a discount rate for high-growth companies?

1- Risk Assessment: Evaluate the specific risks associated with the company's industry, market position, and growth strategy. 2- Cost of Capital: Calculate the weighted average cost of capital (WACC), considering both equity and debt financing costs. 3- Peer Comparison: Analyze discount rates used for similar high-growth companies in the industry. 4- Growth Projections: Adjust the rate to reflect the company’s expected growth trajectory, higher than industry averages. 5- Economic Factors: Consider current economic conditions, such as interest rates and inflation, that impact investment returns. 6- Sensitivity Analysis: Test various discount rates to understand their impact on valuation and find a justifiable median.

The Weighted Average Cost of Capital (WACC) serves as a foundational method, but there are additional considerations when dealing with high-growth firms: - Risk profile - Capital structure - Country risk - Size effect

I agree that standard WACC computation may not reasonably reflect high-growth companies' true cost of capital. However, it is crucial to be careful of potential double-counting of risks. Some factors would be easier to capture in the income stream rather than the discount rate.

I believe the growth rate should be excluded from the WACC and reflected in the cash flows. In case of uncertainty, scenario analysis or sensitivity analysis can be useful. Though it's possible to adjust the WACC, it becomes difficult to quantify reasonably. Personally, I prefer using Monte-Carlo to handle the uncertainty of some key assumptions, such as the growth rate.

I would not recommend adjusting the WACC to deal with the stage of development. However, if the cash flows are less predictable, the preparer could present three scenarios - a base case, an optimistic case, and a pessimistic case. It may not be possible to make adjustments in WACC alone, as it could be challenging to quantify.

One of the often under evaluated risks for high growth company is the steep increase in working capital needs, which can mostly be met by increased debt. This specific risk can be assessed when computing the Cost of Equity by finding comparable companies with above average industry beta. Beta captures both business risk (operating risk) and financial risk. Business risk relates to the company's core operations, while financial risk arises from the use of financial instruments such as debt.

Most professionals are familiar with the "beta" concept when dealing with industry risk. However, there is another concept called "Total Beta" which was introduced by Professor Damodaran. Total beta is similar to regular beta, but it takes into account additional risks that a company may have, especially if it's a small or not frequently traded company. This is important because small or private companies may have different risks that are not reflected in the regular beta. Total beta is particularly useful when you want to determine the value of a company, especially if it's a small or private company.

Further cautious valuation includes scenario analysis by implementing Monte Carlo simulation to move from a deterministic model to a stochastic one. Key, elements of the free cash flow projections can be assigned a statistic distribution with higher volatility, or even "fat tail" distributions such as a Levy distribution. After many iterations of the model including these statistic distributions on key elements, a range of valuation will arise on which a probability can be assignes, which is more realistic than single figure valuations.