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.
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.
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
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.