In this article, we explore the advantages and disadvantages of Discounted Cash Flow (DCF) valuations. DCF is a valuation method primarily used to determine the intrinsic value of a company, considering various aspects of the business to achieve a fair valuation. As Philip Fisher wisely stated, "The stock market is filled with individuals who know the price of everything, but value of nothing.
Pros
- Comprehensive: DCF considers all aspects of a business, analyzing the business model, market dynamics, growth, margins, investments, and risk, providing a holistic view of the company's value.
- Future-oriented: DCF focuses on estimating the present value of future cash flows, offering a forward-looking perspective.
- Cash flow-centric: DCF emphasizes actual cash flows generated, a crucial indicator of a company's value.
- Flexibility: DCF allows adjustments and sensitivity analysis, enabling evaluation under different scenarios and assumptions.
- Time value of money: DCF accounts for the concept that future money is worth less than present money, considering opportunity cost.
- Suitable for long-term investments: DCF captures expected cash flows over an investment's lifespan, making it ideal for long-term valuation.
Cons
- Sensitivity to assumptions: DCF heavily relies on assumptions, such as cash flows, discount rates, and growth rates, making it sensitive to inaccuracies or biases.
- Complexity: DCF involves complex calculations and extensive financial data, challenging for individuals without financial expertise.
- Uncertainty in long-term projections: Forecasting cash flows beyond a few years is difficult, especially in dynamic or uncertain industries.
- Challenging computation of cost of equity and beta.
- Time-consuming: DCF requires creating complex spreadsheets, consuming significant effort and time.
- Difficulties in computing terminal value, including terminal growth, inflation, and cost of capital during the terminal period.
- Limited applicability: DCF may not suit assets with unstable cash flows or industries with uncertain cash flow generation.
- Inapplicable to valuing banking and finance companies.
- DCF is only suitable for valuing going concern companies.
- Neglects non-financial factors like management quality that influence a company's value.
Note: DCF is just one valuation method and should be used alongside other approaches for a comprehensive company valuation.