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 the DCF analysis can be advantageous and disadvantageous depending on the situation it is used. The two succeeding sections discuss the main DCF analysis pros and cons.
Source: CFI financial modeling courses.
Pros and Cons
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
- Terminal value is hard to estimate and represents a large portion of 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.
Read more about valuation
This has been a guide to the main DCF Analysis Pros & Cons. To continue learning about company valuation, check out these valuable resources: