The ups and downs of the discounted cash flow method
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What is Discounted Cash Flow DCF analysis?
Discounted cash flow DCF analysis determines the present value of a company or asset based on the value of money it can make in the future. The assumption is that the company or asset is expected to generate cash flows in this time frame. In other words, the value of money today will be worth more in the future. The DCF analysis is also useful in estimating a company’s intrinsic value. This article breaks down the most important DCF Analysis pros & cons.
Using DCF analysis can be advantageous and disadvantageous depending on the situation it is used for. The two succeeding sections discuss the main DCF analysis pros and cons.
Source: CFI financial modeling courses.
Pros and Cons of DCF Analysis
What are the Pros of DCF analysis?
It would be best for a financial analyst to use the DCF analysis if they are confident about the assumptions being made. A discounted cash flow model requires a lot of detail to make an estimate of the intrinsic value of a stock, and each of those details requires an assumption.
The main Pros of a DCF model are:
- Extremely detailed
- Includes all major assumptions about the business
- Determines the “intrinsic” value of a business
- Does not require any comparable companies
- Can be performed in Excel
- Includes all future expectations about a business
- Suitable for analyzing mergers and acquisition
- Can be used to calculate the internal rate of return IRR of an investment
- Scenarios can be built-in
- Allows for sensitivity analysis
What are the Cons of DCF analysis?
Despite the advantages of the DCF analysis, it is also exposed to some disadvantages. The main drawback of DCF analysis is that it’s easily prone to errors, bad assumptions, and overconfidence in knowing what a company is actually “worth”.
The main Cons of a DCF model are:
- Requires a large number of assumptions
- Prone to errors
- Prone to overcomplexity
- Very sensitive to changes in assumptions
- A high level of detail may result in overconfidence
- Looks at company valuation in isolation
- Doesn’t look at relative valuations of competitors
- Terminalvalue is hard to estimate and represents a large portion of the total value
- Challenging to estimate the Weighted Average Cost of Capital(WACC)
When should discounted cash flow analysis be used?
A financial analyst should be aware of the advantages and disadvantages of the DCF analysis as mentioned above. It also takes repeated practice for an analyst to become proficient or even skilled at building financial models.
DCF analysis is best used with other tools in order to have a check and balance mechanism to validate the results.
Other valuation methods commonly include:
These methods combined with a DCF model can be displayed in a Football Field Chart (as shown below).
To learn how to build a DCF model, launch CFI’s financial modeling courses.
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FAQs
Doesn't Consider Valuations of Competitors: An advantage of discounted cash flow — that it doesn't need to consider the value of competitors — can also be a disadvantage. Ultimately, DCF can produce valuations that are far from the actual value of competitor companies or similar investments.
What is the DCF valuation method and why is it not that good? ›
DCF Valuation is an ever-changing target that demands constant vigilance and modification. If any expectations about the company change, the fair value will change accordingly. DCF Model is not suited for short-term investing. Instead, it focuses on long-term value creation.
What are the problems with DCF valuation? ›
The main Cons of a DCF model are:
Prone to errors. Prone to overcomplexity. Very sensitive to changes in assumptions. A high level of detail may result in overconfidence.
What are the advantages and disadvantages of discounting techniques? ›
Advantages of using discounted cash flow analysis include considering the time value of money and providing a more accurate measure of profitability. Disadvantages include sensitivity to input parameters and potential for bias.
What is a potential problem with DCF analysis? ›
The first mistake seen in DCF models is accidentally including the latest historical period as part of the Stage 1 cash flows. The initial forecast period should consist of only projected free cash flows (FCFs) and never any historical cash flows. The DCF is based on projected cash flows, not historical cash flows.
When would you not use DCF? ›
PreviousWhat are the principle for cash flow estimation? We do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech start-up) or when debt and working capital serve a fundamentally different role.
What is DCF most sensitive to? ›
A discounted cash flow (DCF) analysis is highly sensitive to key variables such as the long-term growth rate (in the growth perpetuity version of the terminal value) and the weighted average cost of capital (WACC).
What is the most important assumption in the DCF? ›
The five most important DCF assumptions are: (1) Revenue and cost projections, (2) discount rate, (3) terminal value, and (4) growth rates.
Is DCF the best way to value a company? ›
Theoretically, the DCF is arguably the most sound method of valuation. The DCF method is forward-looking and depends more on future expectations rather than historical results.
What are the pros and cons of discount pricing strategy? ›
Pro: Great to boost sales and gain new customers. Con: Excessive discounting can lead to financial loss and harm brand reputation. As well, you could be missing the opportunity to target specific customer segments. Ex: Walgreens offering 50% off on CeraVe, Clean&Clear, and Aveeno.
Disadvantages Of Offering Discounts Too Often
- You risk damaging the reputation of the brand.
- You risk getting into a price war with the competition and being seen as a commodity.
- Discounting can end up hurting your profit margins.
- Potential customers may question the quality of your product/service.
High discount rates mean that it's more costly for commercial banks and other financial institutions to borrow money from the Federal Reserve. This can have ripple effects across the economy. High discount rates can increase other interest rates, making it more expensive to borrow money.
What are the advantages and disadvantages of relative valuation? ›
The strengths of relative valuation are also its weaknesses. First, the ease with which a relative valuation can be put together, pulling together a multiple and a group of comparable firms, can also result in inconsistent estimates of value where key variables such as risk, growth or cash flow potential are ignored.
What are the pros and cons of payback method cash flow analysis and break even analysis? ›
Payback period advantages include the fact that it is very simple method to calculate the period required and because of its simplicity it does not involve much complexity and helps to analyze the reliability of project and disadvantages of payback period includes the fact that it completely ignores the time value of ...
What are the benefits of free cash flow valuation? ›
Benefits of Free Cash Flow
Because FCF accounts for changes in working capital, it can provide important insights into the value of a company and the health of its fundamental trends. A decrease in accounts payable (outflow) could mean that vendors are requiring faster payment.
What are the advantages and disadvantages of simple payback period as a tool for financial evaluation? ›
The Pay-back Period Method is less complex, and easier to understand and use compared to other investment appraisal techniques. However, it ignores the time value of money, cash flows after the payback period, and profitability, unlike techniques such as net present value or internal rate of return.
