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 flowsCash FlowCash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of CF 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 analysisDCF Analysis InfographicHow discounted cash flow (DCF) really work. This DCF analysis infographic walks through the various steps involved in building a DCF model in Excel. 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 companiesComparable Company AnalysisHow to perform Comparable Company Analysis. This guide shows you step-by-step how to build comparable company analysis ("Comps"), includes a free template and many examples. Comps is a relative valuation methodology that looks at ratios of similar public companies and uses them to derive the value of another business
- Can be performed in ExcelExcel ResourcesLearn Excel online with 100's of free Excel tutorials, resources, guides, cheat sheets, and more! CFI's Excel resources are the best way to learn Excel on your own terms. These guides and articles teach spreadsheet formulas, shortcuts, and functions step-by-step with screenshots, templates, lessons, guides, and more
- Includes all future expectations about a business
- Suitable for analyzing mergers and acquisitionMergers Acquisitions M&A ProcessThis guide takes you through all the steps in the M&A process. Learn how mergers and acquisitions and deals are completed. In this guide, we'll outline the acquisition process from start to finish, the various types of acquirers (strategic vs. financial buys), the importance of synergies, and transaction costs
- Can be used to calculate the internal rate of return IRRInternal Rate of Return (IRR)The Internal Rate of Return (IRR) is the discount rate that sets the net present value of an investment equal to zero. This guide to calculating IRR will give several examples and who why it's used in capital budgeting, private equity and other areas of finance and investing. If IRR is greater than cost of capital, of an investment
- Scenarios can be built in
- Allows for sensitivity analysisWhat is Sensitivity Analysis?Sensitivity Analysis is a tool used in financial modeling to analyze how the different values for a set of independent variables affect a dependent variable
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 valuationValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance in isolation
- Doesn’t look at relative valuations of competitors
- Terminal valueTerminal ValueThe terminal value is used in valuing a company. The terminal value exists beyond the forecast period and assumes a going concern for the company. is hard to estimate and represents a large portion of total value
- Challenging to estimate the Weighted Average Cost of CapitalWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator (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:
- Comparable company analysisComparable Company AnalysisHow to perform Comparable Company Analysis. This guide shows you step-by-step how to build comparable company analysis ("Comps"), includes a free template and many examples. Comps is a relative valuation methodology that looks at ratios of similar public companies and uses them to derive the value of another business
- Precedent transactionsPrecedent Transaction AnalysisPrecedent transaction analysis is a method of company valuation where past M&A transactions are used to value a comparable business today. Commonly referred to as “precedents”, this method of valuation is used to value an entire business as part of a merger/acquisition commonly prepared by analysts
These methods combined with a DCF model can be displayed in a Football Field ChartFootball Field Chart TemplateA football field chart is used to display a range of values for a business. Download our FREE Excel football field chart template and learn how to make one. (as shown below).
Football Field Chart TemplateA football field chart is used to display a range of values for a business. Download our FREE Excel football field chart template and learn how to make one.
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:
- Valuation MethodsValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance
- Gordon Growth ModelGordon Growth ModelThe Gordon Growth Model – also known as the Gordon Dividend Model or dividend discount model – is a stock valuation method that calculates a stock’s intrinsic value, regardless of current market conditions. Investors can then compare companies against other industries using this simplified model
- Price-to-Earnings RatioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share. It gives investors a better sense of the value of a company. The P/E shows the expectations of the market and is the price you must pay per unit of current (or future) earnings
- Financial modeling guideFree Financial Modeling GuideThis financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, Excel modeling and much more. Designed to be the best free modeling guide for analysts by using examples and step by step instructions. Investment banking, FP&A, research
