The Advantages and Limitations of

Discounted Cash Flow Analysis

What Is Discounted Cash Flow?
Discounted cash flow is a type of analysis that determines the value of a company or an
investment based on what it might earn in the future. The analysis tries to ascertain the
current value of projected future earnings.

What Is a Discounted Cash Flow Analysis?

Discounted cash flow analysis refers to the use of discounted cash flow to determine an
investment’s value based on its expected future cash flows. Experts refer to the process
and the accompanying formulas as a discounted cash flow model.

Benefits and Drawbacks of Discounted Cash Flow

People use the discounted cash flow method to judge an investment’s fundamental
value. This differs from simple market sentiment, wherein you evaluate the investment
based on how a stock exchange values a company’s stock or the marketplace values
similar companies.

As its main benefit, a discounted cash flow analysis uses financial numbers that are
based in reality: cash flow generated by the business. By contrast, the other primary
valuation methods (comparable company analysis and precedent transaction analysis,
explained below) rely on outsiders’ beliefs or conjectures about the value of a company
or stock compared to similar companies or investments. These models can be
inaccurate, as the analysis might not reflect the fundamental financial health of the
company.

That said, discounted cash flow has drawbacks — notably, it relies on projections of
future cash flow. While these projections are based on current cash flow, at best they
are attempts to predict the future. They can be very inaccurate, especially when
analysts are trying to predict cash flow several years into the future. Those inaccuracies
can in turn result in an incorrect value as determined by the discounted cash flow
analysis.

 Advantages of a Discounted Cash Flow Analysis

 The main advantages of a discounted cash flow analysis are its use of precise numbers
and the fact that it is more objective than other methods in valuing an investment. Learn
about alternate methods used to value an investment below.

Here are some of the primary advantages of a discounted cash flow analysis:

 Extremely Detailed: It uses specific numbers that include important assumptions about
a business, including cash flow projections, growth rate, and other measures to arrive at
a value.
 Determines the “Intrinsic” Value of a Business: It calculates value apart from
subjective market sentiment and is more objective than other methods.
 Doesn’t Need to Use Comparables: DCF analysis does not require market value
comparisons to similar companies.
 Considers Long-Term Values: It assesses the earnings of a project or investment
over its entire economic life and considers the time value of money.
 Enables Objective Comparison: DCF analysis allows you to analyze different types of
companies or investments, and to arrive at an objective and consistent valuation for all
of them.

“The most powerful thing about discounted cash flow ... [is that] it’s really useful to
compare assets that are completely different,” says Ryan Maxwell, a former financial
analyst with Deutsche Bank and Chief Financial Officer at FirstRate Data, a boutique
financial data firm. “If you’re interested in buying a copper mine, how do you compare
that with a stock? How do you evaluate those? They are completely different
investments. The best tool for that is DCF — provided they both have an income
stream. It requires there be some sort of cash flow.”
 Can Be Performed in Excel: While specialized software can help you perform a
discounted cash flow analysis, you can also execute the analysis using an Excel
spreadsheet.
 Suitable for Analyzing Mergers and Acquisitions: The objectivity ensured by
discounted cash flow analysis helps company leaders judge whether a company should
merge with or acquire another company.
 Calculates Internal Rate of Return: Performing discounted cash flow analysis can
help companies calculate the internal rate of return (IRR) on investments, which allows
them to compare the value of competing investments.
 Allows for Sensitivity Analysis: The discounted cash flow model allows experts to
assess how changes in their assumptions of an investment would affect the final value
the model produces. Those variable assumptions might include cash flow growth or the
discount rate pegged to making the investment.

You can use a template to see how changes in either the projected growth rate or the
discount rate in a discounted cash flow analysis would affect the value of the original
analysis you calculated for the investment. Download this free template and customize it
with your own figures.

 Disadvantages of a Discounted Cash Flow Analysis

 A discounted cash flow analysis also has limitations, as it requires you to collect a
significant amount of data and relies on assumptions that can, in some cases, be
wrong.

Here are the primary limitations or disadvantages of a discounted cash flow analysis:

 Requires Significant Data, Including Data on Projected Revenue and

Expenses: Performing a discounted cash flow analysis requires a significant amount of
financial data, including projections for cash flow and capital expenditure over several
years. Some investors might find it is difficult to gather the needed data; even simple
processes take some time.
 Sensitive to the Projections It Relies On: The analysis is very sensitive to its
variables, which include projections of future cash flow, the investment’s perpetual
growth rate, and the discount rate that experts believe is proper for the investment.

“You’re taking what is a hard job — forecasting maybe 10 years of cash flow — and
making it very, very hard by saying, ‘I now need to forecast that really into perpetuity,’”
says Ray Wyand, a former Vice President at Citibank in structured finance and the CEO
of Gini, a company that offers machine learning tools to help businesses improve the
quality of their cash flow forecasting. “The problem is, at that point, it’s enormously
sensitive. So the difference between a 9 percent growth rate and a 12 percent growth
rate — you go from being a midsize company to taking over the world.”
 Analysis Depends on Accurate Estimates: A discounted cash flow analysis is only as
good as the estimates and projections it uses.

“Discounted cash flow depends on the quality of the cash flow projections,” says
Christian Brim, a certified public accountant and CEO of Core Group, a company that
helps small businesses grow profitably with better financial information. “When you’re
dealing with a situation where there are a lot of unknowns … and it’s hard to project the
cash flows … DCF is really kind of meaningless.”

To see how inaccurate projections for future cash flow can provide a very inaccurate
value for a company or investment, download this example of a hypothetical discounted
cash flow analysis of Amazon in 2015. It shows a discounted cash flow analysis that
projects future Amazon cash flow based on past cash flow up to 2014. It arrives at a
value of Amazon stock that is much lower than its actual value in early 2015 or its later
stock value.