DCF Analysis Pros & Cons

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 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

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 works. 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! CFI's resources are the best way to learn Excel on your own terms.
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 makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment. 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 in isolation
Doesn’t look at relative valuations of competitors
Terminal valueTerminal ValueTerminal Value (TV) is the estimated present value of a business beyond the explicit forecast period. TV is used in various financial tools is hard to estimate and represents a large portion of the 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. (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.