Equity Financing, Dilution, and Consistency in DCF Valuation
Summary
The document discusses valuation of a pre-revenue biotech company expected to fund operating costs through future equity issuance. The answer cautions that cash raised through financing does not belong in free cash flow, which is intended to capture operating cash generation rather than financing flows. It also challenges the suitability of a conventional free-cash-flow model paired with a stable weighted average cost of capital when the company's capital structure changes substantially, and points to an abnormal earnings approach as an alternative worth considering.
On dilution and distributions, the response emphasizes internal consistency: a valuation model that includes share distributions must reflect them in dividends and earnings, while a model that omits them must use the corresponding growth assumptions. Properly specified approaches should produce the same per-share value under the stated irrelevance principle. The answer does not lay out a complete biotech valuation or explain forecast share-count mechanics in detail. Its guidance is conceptual and depends on consistent accounting and model assumptions.
Key ideas
- Free cash flow excludes cash flows from financing such as proceeds from equity issuance.
- A volatile capital structure may make a standard free-cash-flow model with WACC less suitable.
- An abnormal earnings model is offered as an alternative that avoids forecasting debt-to-equity ratios.
- Share distributions, earnings, dividends, and growth assumptions must be handled consistently.
- The response does not provide a full implementation for forecasting dilution in this biotech case.
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Full text
# How to handle cash from financing in a DCF model? # How to handle cash from financing in a DCF model? I am building a valuation model for a public pre-revenue company (biotech). The company is going to have ~$600M in R&D and SG&A expenses over the next 4 years, which it is going to finance with equity raises. After that, the company is projected to become profitable and the margins will gradually improve. I have a consensus sell-side forecast until the year 2036 that includes the revenues, costs, equity raises, and the number of shares at the end of each year. My questions are: - Should I include the cash from the equity raises in my DCF model? - Should I account for dilution and the projected increase in the number of shares throughout my forecast period? Right now, I have included all cash flows (including cash from financing) in my FCF and divided all the FCFs by the corresponding number of shares before discounting. I see that this is not the way the sell-side models are built though. Can someone knowledgeable about this explain to me what I am doing wrong, what is the most principled way to do the DCF valuation in this case, and why? Thanks a million! ## Answer by Mild_Thornberry (score 2, accepted) https://quant.stackexchange.com/a/63738 Lucky for us, the method you’re describing is unnecessarily complicated. M&M state that distributions have no impact on firm value, so why would it in your model? Check out Valuation Models: An Issue of Accounting Theory by Stephen Penman. In it, he shows how the Free Cashflow model is only valid insofar as it matches the Dividend Discount model via accounting manipulation. So I would step back and consider if FCF model + some sort of WACC is right for you, since the capital structure of the firm in question is so variable. Why not do an Abnormal Earnings model? Then you don’t have to worry about debt/equity ratios. To address your point though, Share Repurchases and Stock Valuation Models shows that as long as you are consistent, your valuations will the the same. That is, if you include share distributions, you better include it in dividends and earnings. That will get you a certain growth factor. If you don’t include it, you get a different growth factor. Correctly specified models will always end up at the same price because, again, M&M proves dividend policy irrelevancy. Also, I can’t quite be sure from your question, but it seems like you may be confused as to the definition of Free Cash Flow. You should look it up just on investopedia. There’s no place for cash flow from financing in that formula.
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