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Pros and Cons of DCF Analysis

Understand the Pros and Cons of the DCF Approach

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Pros and Cons of DCF Analysis

Discounted Cash Flow (DCF) Overview

The discounted cash flow (DCF) analysis values a company under the premise that its value is equal to the sum of its future cash flows, discounted at an appropriate rate.

The discount rate used should reflect the risks associated with the company’s cash flows – or said differently, represent the required rate of return based on investments with comparable risk.

DCFs are used to judge the fundamental value of a company, which differs from market-based valuations that rely on investor sentiment, wherein a company is valued based on how the market values comparable companies.

DCF Pros

Intrinsic Valuation

The DCF method is a fundamentals-oriented approach, so the implied valuation is a function of the company’s projected free cash flows (FCFs) and the cost of capital (i.e. discount rate) assumption.

In fact, the reliance of the DCF on discretionary assumptions regarding future financial performance is the reason that the DCF is viewed as a more academically rigorous approach to measuring value.

The specific underlying drivers of the valuation are explicitly modeled – i.e. the assumptions related to revenue growth, profitability margins, free cash flows – causing the DCF-derived valuation to be more defensible as specific assumptions can be discussed in detail.

Market-Independence

Furthermore, the DCF analysis is independent of the market, so the current trading price should be neglected and not impact the ending valuation.

The market can be and often is wrong on the pricing of a company – and the DCF is unaffected by temporary market distortions and the mispricing of securities.

Another benefit to the DCF approach is that the valuation is self-sufficient and not dependent on the existence of similar companies/transactions.

For instance, if there are no “pure-play” comparables or a limited number of peers, the DCF can still be used as it does NOT require the existence of any comparable companies.

DCF Cons

Sensitivity to Assumptions

The reliance on assumptions is the main drawback of the DCF approach, in which minor adjustments to key assumptions could have material impacts on the DCF valuation.

Since each assumption can have a sizeable impact on the firm’s valuation, the accuracy of the valuation is a function of the financial projections (i.e. “garbage in, garbage out”).

In particular, projecting a company’s financials accurately becomes even more challenging for early-stage companies.

Terminal Value Contribution

The present value (PV) of the terminal value can account for upwards of three-quarters of the valuation – which is a major source of criticism given the relatively simplistic calculation of the terminal value.

For example, in the perpetuity growth approach to estimating the terminal value, the GDP growth rate or risk-free rate (i.e. 1% to 3%) is typically used as a proxy for the company’s long-term growth rate.

The perpetuity growth rate should reflect the “steady-state” period when growth has gradually slowed down to a normalized, sustainable rate – but the growth rate cannot accurately be calculated.

At a certain point, simple assumptions are required beyond the Stage 1 forecast period.

Fixed Capital Structure

The final disadvantage of the DCF approach is that the company’s capital structure is assumed to remain constant.

Companies tend to gradually take on more debt financing as they mature, but factoring this into a DCF can be impractical, especially since increased debt reliance is not a certainty, either.

While an adjusted capital structure can be assumed in a DCF model – with the D/E ratios of comparable mature companies used as a point of reference – the distinction between “sub-optimal” and “optimal” capital structures is subjective.

DCF Sensitivity Analysis

The DCF output should be viewed as an “estimation” of a company’s value rather than a “precise calculation” of how much a company is worth.

These approximations of company valuations should be viewed as a range of values instead of a single value, which is why sensitivity analysis is a critical step in any DCF analysis.

In a sensitivity analysis, the most influential variables are selected and then sensitized to assess their impact on the implied share price (and total valuation).

The most important variables to sensitize are the following:

  • Cost of Capital – i.e. Weighted Average Cost of Capital (WACC)
  • Terminal Value Growth Rate Assumption / Exit Multiple
  • Revenue Growth Rate and Operating Assumptions (e.g. Operating Margin, EBITDA Margin)

While operating assumptions like revenue growth are often sensitized in DCF models, the discount rate is typically more important (and impactful on the overall valuation).

DCF Pros and Cons Conclusion

The different valuation methods, including both intrinsic and relative valuation approaches, should be used in conjunction to arrive at a range of valuation estimates.

By using more than one valuation method, the resulting estimated value is more reliable, as each approach serves as a sanity check on the other method.

If the output from each valuation method deviates irrationally far from each other, it is recommended to revisit the assumptions and adjust if deemed necessary.

For the most part, especially for companies with wide followings by equity analysts and investors, the implied DCF valuation should be within the same ballpark as the current trading price.

Otherwise, there is most likely a significant error in the model causing the anomalies.

Therefore, relative valuation methods can provide a market-based sanity check to the intrinsic valuation obtained from a DCF analysis (and vice versa).

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