Pros and Cons of DCF Analysis

The ups and downs of the discounted cash flow method​

What is the discounted cash flow 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.

Using the DCF analysis can be advantageous and disadvantageous depending on the situation it is used. The two succeeding sections discuss the pros and cons of this analysis.

What are the pros of the discounted cash flow analysis?

It would be best for a financial analyst to use the DCF analysis if he/she is confident about the assumptions made. This is because DCF can well estimate the intrinsic value of a stock. It is also useful when future cash flows look very promising.

DCF analysis also takes great consideration of the company’s expectations, making it less susceptible to changes in external factors.

Aside from this, free cash flows – which are accepted as a reliable measure – are used in DCF analysis. Free cash flows are not easily influenced by some arbitrary policies in accounting and finance. As such, DCF analysis will also not be affected by market conditions and other factors in the short-term period.

What are the cons of the discounted cash flow analysis?

Despite the advantages of the DCF analysis, it is also exposed to some disadvantages. One of this is that it is prone to vary with company objectives and prospects; this will change the fair value.

Additionally, DCF can be easily influenced by time when compared to other valuation methods. An analyst may also find it difficult to use the DCF analysis when a company is not transparent with its operations; this will make it difficult to predict the company’s future status.

Finally, the DCF analysis cannot be used on companies which are just starting because since they still usually do not have the assumption of stability needed to make the analysis accurate.

When should the 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 understand the situations where the DCF analysis can be best applied.

DCF analysis is best used with other tools in order to have a check and balance mechanism to validate the results. Furthermore, if there is stability and ease in forecasting cash flows, the DCF analysis results to a very reliable intrinsic value.

Read more about the DCF model