What is Discounted Cash Flow Analysis? Pros and Cons

DCF, or discounted cash flow analysis, is a popular valuation method employed by companies to assess a business or investment. This analysis method works well when a company’s operations are consistent and predictable. It uses valuation approaches to determine whether the businesses’ future cash flows will be worthy. 

Discounted cash flow analysis has many advantages and limitations. Here, we will explore what DCF is, and its pros and cons.

What is Discounted Cash Flow (DCF) analysis? 

Discounted cash flow or DCF analysis establishes the current value of a company or asset based on its expected future value. This analysis is built on the assumption that the company will generate cash flows within this time or that the current value of money will increase in the future. 

When the DCF is more than the current investment cost, the returns are expected to be positive and worthwhile. If the final value is less than the cost, then the opportunity is not good. It may also signal the need for another round of research and analysis. Companies also use the weighted average cost of capital (WACC) to consider the return rate the shareholders expect. DCF analysis is useful when an investor pays money currently and hopes to get more money in the future. 

Discounted Cash Flow: The Advantages and Disadvantages

The discounted cash flow is one of the most useful methods to determine an investment’s value. It uses real financial numbers like cash flow generated by the business. Unlike other valuation approaches like comparable company analysis, precedent transaction analysis, etc., this method is more reliable and does not consider outsiders’ beliefs about company value or stock. 

However, discounted cash flow analysis has limitations too. Since DCF is based on future prediction, it can be inaccurate, leading to incorrect values. Here, we explore the pros and cons of DCF in detail. 

Discounted Cash Flow Analysis: The Pros 

Below mentioned are the main advantages of a discounted cash flow analysis: 

• Detailed and Reliable 

DCF analysis is mostly reliable because it is based on specific numbers while projecting cash flow, growth rate, and other detailed parameters. 

• Finds the “Intrinsic” Value 

Unlike other methods, DCF analysis is not based on subjective market sentiment. This analysis permits you to assess various companies or investments to reach an objective valuation. Since it employs a more objective approach, business owners can determine the intrinsic value of the business. 

• No Comparable Used 

DCF analysis does not determine market value by comparing companies in the same industry. Rather, the best thing about discounted cash flow is that it can compare assets from completely different domains. 

• Long-Term 

The discounted cash flow analysis evaluates the investment gains over a long period. 

• Does not Require Specialized Software 

DCF can be prepared in a regular Excel sheet. You don’t need to use or install special software to reach your goals. 

• Helps to Analyze M&A 

DCF analysis allows company managers to decide whether to merge or acquire another company. 

• Calculates IRR 

The Internal Rate of Return, or IRR, on investments, can be calculated using DCF analysis. This allows companies to compare the value of competing investments. 

• Enables Sensitivity Analysis 

The DCF model can help you evaluate how investment changes affect the model value. Variables like cash flow growth, discount rate, etc., are needed. The template can show you the projected growth rate or the discount rate changes that affect analysis value. 

Discounted Cash Flow Analysis: The Cons 

Below-mentioned are the drawbacks of a DCF analysis: 

• Needs Data 

Performing a DCF needs a significant amount of financial data, which is sometimes difficult to gather. 

• Requires Accurate Estimates 

A DCF only estimates and projects. It needs high-quality cash flow projections to provide correct value. Sometimes, when the projections are inaccurate, a company’s or investment’s value may also be incorrect. 

• Complex 

The DCF is calculated using complex formulas. Sometimes, people do not understand them easily. 

• Does Not Consider Competitor’s Valuations 

DCF doesn’t consider the competitor’s valuations and market realities, which is an important metric at times. 

• Difficult to Estimate Terminal Value 

The DCFformula is the terminal value of the investment, which is very difficult to estimate. It also generates a large portion of the total value. 

• WACC Difficulties 

DCF uses the Weighted Average Cost of Capital (WACC). WACC is a company’s cost of capital, including all sources. It is challenging to assess this number. 

|Read More: Types of Mergers and Acquisitions

Wrapping Up 

Discounted cash flow offers many advantages but also has some drawbacks. This analysis helps business leaders evaluate whether to acquire a company, buy assets, or make capital budgeting or expenditure decisions. To conduct a DCF, you must consider future cash flow estimates, ending investment value, equipment, other assets, etc.