First Chicago Method Valuation: A Comprehensive Guide

The First Chicago method is a widely used approach for estimating the present value of a firm's future cash flows. It's based on the idea that a company's value is equal to the present value of its expected future cash flows.

This method involves estimating the cash flows that a company is expected to generate over its remaining economic life. The First Chicago method assumes that these cash flows are expected to grow at a constant rate.

The First Chicago method is a relatively simple approach, but it requires a good understanding of the company's financials and industry trends. By using this method, you can estimate the present value of a company's future cash flows and get a rough estimate of its value.

Startup valuation is a complex process, especially for startups with limited data. It's challenging to determine the value of a startup without revenue, but pre-revenue startups often rely on projections of future earnings.

There are several factors that influence startup value, including industry and economic trends, team reputation, number of users and paying customers, growth rate, and profitability.

Some popular revenue-based approaches for mature businesses include the times-revenue method, multiples of earnings method, capitalization of cash flows method, and discounted cash flow method.

For startups, valuation methods like the First Chicago method, venture capital method, and comparable method are often used to estimate value.

Here are 10 of the most useful and popular startup valuation methods:

The discounted cash flow valuation formula is used to estimate the present value of future cash flows.

Pre-money valuation is the valuation of a startup before it receives a round of investment or other outside funding, while post-money valuation is the valuation after a funding round.

To determine post-money valuation, you add the pre-money valuation and the investment, using the formula: Post-Money Valuation = Pre-Money Valuation + Investment.

The amount and frequency of capital raised also influence the value of a startup, with early investors often being the toughest to acquire.

The First Chicago Method is a scenario-based valuation approach that involves creating three different scenarios for a company's future: a best-case scenario, a worst-case scenario, and a most likely scenario.

Each scenario is then assigned a probability, which can range from 10% to 70% as seen in the example where the management estimates the outcomes of these scenarios.

The expected values from each scenario are summed to provide an overall valuation, allowing traders to consider a range of potential outcomes rather than relying on a single, static valuation.

The First Chicago Method is particularly useful in situations where future cash flows are highly uncertain, such as in the case of start-ups or companies in rapidly changing industries.

The method is most often used to value early-stage companies with unpredictable futures, such as venture-backed startups yet to turn a profit.

Here's an example of how the probabilities are assigned in the First Chicago Method:

This approach acknowledges the inherent uncertainty in predicting a company's future and provides a framework for managing this uncertainty.

The First Chicago Method also involves using a discount rate, which can be derived from the return required by the VCs as seen in the example where the 35% discount rate was derived.

The method allows for the estimation of the current fair value of all three scenarios, which can then be combined to provide an overall valuation.

The fair value for the reporting unit is between $8,078,000 & $11,532,000, as seen in the example where the management estimates the outcomes of these scenarios.

The value of a startup is influenced by a multitude of factors, including industry and economic trends, team reputation, and number of paying customers.

Your team is a crucial factor, as a strong and experienced team can significantly increase the value of a startup.

The size of the opportunity, number of paying customers, earnings, and profitability also play a significant role in determining the value of a startup.

Industry life cycle and trends, traction, reputation, and amount and frequency of capital raised are also essential factors to consider.

Here are the top factors that influence startup value:

Factors influencing startup value are numerous and complex, but some key factors stand out. Your team is a crucial factor, as a strong team with the right skills and experience can significantly impact a startup's value.

The size of the opportunity is another important factor, as a startup with a large and growing market can be more valuable than one with a smaller market. The number of paying customers is also a key indicator of a startup's value, as it shows traction and revenue growth.

Earnings and profitability are better indicators of a startup's value than revenue alone, as they speak to the company's true value. Industry life cycle and trends also play a significant role in determining a startup's value, as a startup in a growing industry can be more valuable than one in a declining industry.

Here are some of the top factors that influence startup value:

Traction, reputation, and amount and frequency of capital raised are also important factors that can impact a startup's value.

The First Chicago Method is a valuable tool for assessing factors influencing value, and it's comprised of several key components.

The creation of three scenarios is the first component, which involves a detailed analysis of the company and its industry, including market trends, competitive dynamics, and strategic positioning.

These scenarios should be realistic and based on solid research and analysis.

Assigning probabilities to each scenario is the second component, which requires a degree of judgment and subjectivity.

The goal is not to predict the future with absolute certainty, but rather to provide a range of potential outcomes and their likelihoods.

Entering an emerging industry can be a double-edged sword. You may face an uphill battle convincing customers and investors that your startup's products or services are needed, but new markets offer lucrative opportunities for growth.

The industry life cycle plays a significant role in determining the value of your startup. If you're entering a mature market, you'll face high levels of competition from established industry veterans.

Entering a mature market can be challenging because even if you innovate within your business model, you may be seen as the copycat without a competitive advantage. On the other hand, emerging industries offer potential for growth, but also come with the risk of competition from copycats.

The industry you enter can significantly influence the valuation of your startup. Popular and booming industries have more interested investors than old or stagnant industries.

Here are some key characteristics of different industry life cycles:

The next step in the First Chicago method is to calculate the expected value for each scenario. This is done by estimating the company's future cash flows under each scenario and then discounting these cash flows back to their present value using an appropriate discount rate.

The expected values for each scenario are then multiplied by their respective probabilities to obtain a weighted average. This weighted average is the overall valuation of the company according to the First Chicago Method.

To do this, you can use the SUMPRODUCT function in Excel, as shown in the First Chicago Method Calculation Example. The probabilities for each scenario are determined, and the corresponding valuations are used to calculate the weighted average.

The weighted valuation of $125 million is obtained by using the SUMPRODUCT function with the probability weights and valuations. This figure provides a more nuanced view of the company's potential value, taking into account a range of possible future outcomes.

Here's a summary of the calculation:

Weighted Valuation: $125 million

The First Chicago method is a valuable tool for valuing companies, but like any method, it has its benefits and limitations.

One of the main advantages of the First Chicago method is its flexibility, allowing for the consideration of a wide range of scenarios, making it suitable for valuing companies in volatile or uncertain industries.

This flexibility also enables the incorporation of both quantitative and qualitative factors, providing a more holistic view of a company's value.

The First Chicago method is particularly useful in situations where traditional valuation methods may struggle, such as with start-ups or companies in rapidly changing industries.

Here are some of the benefits of the First Chicago method:

However, the First Chicago method also has its limitations. One of the main criticisms is the subjectivity involved in creating the scenarios and assigning probabilities.

This subjectivity can lead to biased or inaccurate valuations if not done carefully and objectively.

The complexity of the method is another limitation, requiring a detailed understanding of the company and its industry, as well as a high degree of financial modeling expertise.

This can make it less accessible to less experienced traders or those without a strong financial background.

Here are some of the limitations of the First Chicago method:

The First Chicago method, a powerful tool for investment analysis, relies heavily on scenario planning to assess potential outcomes.

The core of scenario planning involves identifying three key cases: base, upside, and downside. The upside and downside cases are less likely to occur, with the downside case typically being the lower likelihood of the two.

In venture investing, most investments are made with the expectation of failure, as the goal is to achieve a few high returns that can offset losses from failed investments.

The base case represents the targeted performance, which is used as a benchmark for late-stage buyout investments and public equities markets.

In contrast, early to mid-stage investing, such as venture capital and growth equity, aims to exceed the base case by a substantial margin.

The reason the worst-case scenario is not considered as likely is not because it's less probable, but because if it were more likely, it wouldn't be worth investing in the first place.

On a similar theme: Why Is Orphan First Kill Not in Theaters?

To determine the divestment price, you'll need to estimate the terminal value of the startup at the time of exit.

Professionals use multiples based on key performance indicators such as revenues and EBIT to determine the exit price.

The exit price is also known as the disinvestment price, and it's essential to use information from similar startups for the market-based approach.

You'll need to find market data providers that specialize in M&A within the venture industry, as information on such transactions is scarce.

Make sure to compare your startup to similar companies in the same stage, industry, and region to get a accurate estimate of the disinvestment price.

Once you have all the required metrics and information, you can determine the disinvestment price.

Estimating the required return for each scenario is a crucial step, as venture capitalists often derive this internally due to the lack of data in the private market. This makes it difficult to replicate investments and their payoffs.

The WACC cost of equity is reduced in financial forecasts due to the lack of debt capital, leading to vague assumptions during the valuation of a startup or early-stage company. This is why it's essential to estimate the market risk in the industry, region, and stage to determine the risk premium.

Designating a probability for each case is the next step, where you'll need to decide on the likelihood of each scenario. These probabilities will be correlated to the number of scenarios and your definition of them, but it's impossible to be precise in every case.