Advantages and Disadvantages of Discounted Cash Flow | Smartsheet (2024)

Was ist Discounted Cashflow?

Discounted Cashflowis a type of analysis that determines the value of a company or investment based on possible future returns. The analysis attempts to determine the current value of projected future profits.

What is Discounted Cash Flow Analysis?

Discounted-Cashflow-Analyserefers to the use of discounted cash flow to determine the value of an investment based on expected future cash flow. Experts refer to the process and its associated formulas asDiscounted-Cashflow-Modell.

Advantages and disadvantages of discounted cash flow

The discounted cash flow method is used to assess the fundamental value of an investment. This is different from simple market sentiment, where you evaluate the investment based on how an exchange values ​​a company's shares or the market values ​​similar companies.

The main advantage of a discounted cash flow analysis is that it uses real financial numbers: the cash flow generated by companies. In contrast, other primary valuation methods (Comparable Company Analysis and Precedent Transaction Analysis, discussed below) rely on outsiders' beliefs or assumptions about the value of a company or stock compared to similar companies or investments. These models may be inaccurate because the analysis may not reflect the underlying financial condition of the company.

Apart from that, discounted cash flow has disadvantages - it depends in particular on forecasts of future cash flow. While these forecasts are based on current cash flow, they are, at best, attempts to predict the future. They can be very inaccurate, especially when analysts try to forecast cash flow far into the future. These inaccuracies can in turn lead to an incorrect value determined by the discounted cash flow analysis.

Advantages of discounted cash flow analysis

The main advantages of discounted cash flow analysis are the use of precise numbers and the fact that it is more objective than other methods when evaluating an investment. Find out more about belowalternative methods of evaluating an investment.

These are some of the biggest benefits of discounted cash flow analysis:

  • Extremely detailed:It uses specific numbers that contain key assumptions about a company, including cash flow projections, growth rate and other measures, to arrive at a value.
  • Determines the “intrinsic” value of a company:It calculates the value independently of subjective market sentiment and is more objective than other methods.
  • Does not require comparison values:DCF analysis does not require a market value comparison with similar companies.
  • Considers long-term values:It evaluates the income of a project or investment over its entire economic life and takes into account the time value of money.
  • Allows objective comparison:DCF analysis allows you to analyze different types of companies or investments and evaluate them all objectively and consistently.

    “The best thing about discounted cash flow... [It is] very useful for comparing assets that are completely different,” says Ryan Maxwell, a former financial analyst at Deutsche Bank and chief financial officer atFirstRate Data, a small financial data company. “If you're interested in buying a copper mine, how do you compare that to a stock? How do you rate them both? They are completely different investments. The best tool for this is DCF – assuming both have an income stream. There has to be some kind of cash flow.”

  • Can be done in Excel:You can perform a discounted cash flow analysis using special software or even a spreadsheet in Excel.
  • Suitable for analyzing mergers and acquisitions:The objectivity provided by discounted cash flow analysis helps executives assess whether a company should merge with or acquire another company.
  • Calculates the internal rate of return:Conducting discounted cash flow analysis can help companies calculate the internal rate of return on investments, allowing 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 about an investment would affect the final value of the model. These variable assumptions may include cash flow growth or the discount rate tied to the investment.

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

Advantages and Disadvantages of Discounted Cash Flow | Smartsheet (1)

Download Discounted Cash Flow Sensitivity Analysis document - MicrosoftExcel

Disadvantages of a discounted cash flow analysis

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

These are the major limitations or disadvantages of discounted cash flow analysis:

  • Requires a lot of data, including data on projected income and expenses:Conducting a discounted cash flow analysis requires a significant amount of financial data, including forecasts of cash flow and investments over several years. Some investors may find it difficult to collect the necessary data because even simple processes take time.
  • Sensitive to the forecasts on which it relies:The analysis is very sensitive to its variables, including projections of future cash flow, the investment's constant growth rate, and the discount rate that experts deem appropriate for the investment.

    “You take a difficult task—forecasting maybe 10 years of cash flow—and make it even more difficult by saying, 'I now have to forecast this for the long term,'” says Ray Wyand, a former vice president of structured finance at Citibank and CEO ofGini, a company that provides machine learning tools to help companies improve the quality of their cash flow forecasts. “The problem is that the whole thing is extremely sensitive at this point. The difference between a 9 percent growth rate and a 12 percent growth rate is comparable to a medium-sized company and one of the largest companies in the world.”

  • The analysis depends on accurate estimates:A discounted cash flow analysis is only as good as the estimates and forecasts it uses.

    “Discounted cash flow depends on the quality of the cash flow forecasts,” says Christian Brim, certified public accountant and CEO ofCore Group, a company that helps small businesses grow profitably with better financial information. "If you have a situation where there are a lot of unknowns... and it's difficult to forecast the cash flows... DCF doesn't really make sense."

    To see how inaccurate forecasts of future cash flow can provide very inaccurate value to a business or investment, download this example of a hypothetical discounted cash flow analysis from Amazon from 2015. It shows a discounted cash flow analysis that forecasts Amazon's future cash flow based on past cash flow through 2014. The result for the value of an Amazon share is significantly lower than the actual value for early 2015 or later.

Advantages and Disadvantages of Discounted Cash Flow | Smartsheet (2)
  • Depends on confidence in future cash flows:Because forecasts and assumptions must be accurate to provide reliable valuations, analysis works best when you have high confidence in an investment's future cash flows.

    “That's the main problem with DCF: It grinds to a halt if you don't have regular or very predictable cash flows,” says FirstRate Data's Maxwell.

    “As a business owner, I don’t always know how I’m going to get from A to B,” Brim says. “Discounted cash flow—or pretty much any financial measure—is essentially a linear calculation. Things are assumed to be constant, but that’s not how business works.”

  • Prone to complexity:Due to the data required for the discounted cash flow formulas, the analysis can become very complex.
  • Details can lead to overestimation:Because detailed data and forecasts are used to perform a discounted cash flow analysis, one may have more confidence in the resulting valuation than one should. The valuation is still based only on future forecasts.
  • Does not take into account reviews from competitors:The advantage of discounted cash flow in not having to take into account the value of competitors can also be a disadvantage. Ultimately, DCF can result in valuations that are far removed from the actual value of competing companies or similar investments. This can mean that these values ​​from other companies are wrong - but it can also mean that the discounted cash flow analysis does not take into account the reality of the market and is wrong in and of itself.
  • The challenge of final values:An important part of the discounted cash flow formula is theFinal valueof the investment, i.e. the present value of a company or an investment at the end of the multi-year forecast period. This terminal value may represent the assumed cash flow of all future years beyond the forecast period or the total value of the business or investment if it were sold at the end of the forecast period. Either way, the final value is very difficult to estimate. It also generates a large portion of the total value that the discounted cash flow formula outputs.
  • Difficulties with weighted average cost of capital:Discounted cash flow analysis also uses the in its formulaweighted average cost of capital (WACC)of the affected company, which represents the cost of capital of each source in the company. It can be difficult to accurately evaluate this number.
  • Not versed in evaluating vastly different types of investments:Discounted cash flow can value very different types of investments as long as they all have reasonably predictable cash flow. However, valuing investments of different sizes, with very different cash flow forecasts, or with varying levels of confidence in those forecasts, is more problematic.

    “If you compare completely different situations, for example a startup with a listed company, there are too many differences,” says Core Group’s Brim.

Evaluate Companies: Details on the three primary evaluation methods

Evaluation methodDiscounted CashflowComparable company analysisprecedents
How is it achieved
  • Uses a company's actual free cash flow, cash flow forecasts, and other defined variables to determine a value
  • Uses financial figures and ratios of similar publicly traded companies to determine the value of the subject company
  • Considers recent transactions with similar companies, particularly mergers and acquisitions

Advantages
  • Based on fundamental company financials
  • Not influenced by volatile market perception factors
  • Shows how the market values ​​companies with similar financial ratios and ratios
  • Based on real data as opposed to future cash flow assumptions
  • Shows what actual buyers were willing to pay for similar businesses
restrictions
  • Based on future predictions that may be incorrect
  • Valuation can vary greatly depending on how different the forecasts are
  • Less useful for fast-growing, unpredictable companies
  • Not linked to what buyers pay for something similar
  • Finding truly comparable companies and transactions can be difficult
  • May be overly influenced by temporary market conditions
  • Finding truly comparable transactions can be difficult
  • The quality of information on comparable transactions is not always high
  • Highly influenced by temporary market conditions
Most commonly used for
  • Established and stable companies
  • Companies in industries with predictable cash flow
  • Start up Company
  • Technology company
  • IPOs
  • When attempting to value a company that may be part of a merger or acquisition

Alternatives to Using Discounted Cash Flow

Experts use three primary alternatives to evaluate companies or investments. In addition to Discounted Cash Flow, the other primary valuation methods are Comparable Company Analysis and Precedent Transaction Analysis.

When to Use Discounted Cash Flow

Advantages and Disadvantages of Discounted Cash Flow | Smartsheet (3)

Discounted cash flow should be used to evaluate the value of an investment when the cash flow is relatively stable and predictable.

Discounted cash flow mostly works in the following cases:

  • When a company's operations (or returns on investment) are consistent and can be predicted with some degree of certainty:Discounted cash flow is primarily the result of valuing bonds that have very predictable returns, says Gini's Wyand. “It works really well when you have stable cash flows that you can predict,” he says. Essentially, it provides “the value of all remaining cash generated by the company.”
  • If a company derives its income from different sources:Using a different valuation method may be difficult in such cases as there would be no similar companies that would allow for comparable analysis.
  • When value-oriented investors evaluate a company:These are investors who want to buy stocks of companies that appear to be undervalued based on a fundamental analysis of their financial results. In these cases, value-oriented investors can perform discounted cash flow analysis to determine whether the company's future cash flows will be worth more money than the market is saying.
  • In investment banking:Many experts believe that discounted cash flow is better suited for determining the value of private equity capital held by investment bankers than of stocks in many publicly traded companies.
  • When investing in real estate:Because the analysis works very well with stable and predictable cash flows, DCF "is, in my opinion, a very good method if you're purchasing a home as an investment," says Wyand.

When not to use discounted cash flow

Discounted cash flow works less well when future cash flow may vary or be unpredictable.

Cases where discounted cash flow analysis would not work well

  • Companies with cyclical sales:For companies whose revenue varies widely based on business cycles, discounted cash flow is difficult to use. These can include, for example, companies in the housing construction sector. It becomes more difficult every year to forecast future revenue.
  • Internal evaluation of new products:Companies often want to conduct an internal evaluation of a potential new product. Discounted cash flow can only provide limited value in this case. “In an internal assessment, I think it can be a blunt instrument: ‘Should we launch this product or invest more in an existing product?’” says Core Group’s Brim. “It may provide better data for your cash flow forecasts. However, it doesn't capture everything that you can't measure, like 'How does this impact the company culture or the overall direction of the company?'"
  • Private companies:Private companies may have difficulty obtaining the financial data needed for the formula.
  • Shares:Many experts believe that discounted cash flow is not a good method for valuing many stocks at this time. The price of many stocks would exceed the value that discounted cash flow would suggest. This can mean that stocks are overpriced. But it could also mean that discounted cash flow is not an appropriate way to value stocks in the current market.

    “If you valued listed stocks strictly at DCF, you probably wouldn’t find anything worth buying right now,” says Gini’s Wyand.

  • Start-ups and young companies:They don't have sales success, and it's much harder to forecast cash flow.
  • Technology companies:Many technology companies have significant initial expenses and cash flow is unpredictable for a few or many years. Investors still rate many listed technology companies very highly – including young ones.

    “When you apply DCF to technology companies, you find that they tend to be quite expensive,” says Maxwell of FirstRate Data. According to Maxwell, if an investor had relied on discounted cash flow analysis to assign value to technology companies in recent years, one would have "missed the opportunity" to benefit from the significant increase in share price by not buying the stock .

Determine discount rates when valuing assets

Thediscount rateis a very important variable in Discounted Cash Flow because it allows you to assess what it costs a company to generate cash flows. It also allows you to assign a risk level to an investment.

The formula contains the discount rateweighted average cost of capitalof the company concerned, i.e. the different ways a company can access capital to pay for infrastructure and operations.

For companies and investments that are riskier, experts increase the discount rate. This lowers the final value of a risky investment compared to a less risky investment. The concept understands that the buyer should pay less if they accept the risk that the company will generate less revenue than forecast or have to go out of business completely.

“Generally speaking, (the discount rate) is the risk of the project,” says Maxwell of FirstRate Data. “You invest in a restaurant or utility company. The restaurant poses a much greater risk. The discount rate should be much higher.”

An expert can also raise the discount rate for certain companies in certain situations. For example, for a business that is forced to close or partially close during a pandemic, the discount rate must be higher.

“Essentially, these discount rates are intended to capture the risk of an investment,” says Wyand. “If you can properly analyze discount rates and predict what discount rates should be, then you will be the richest person in the world. This is very, very difficult.”

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As an expert in financial analysis and valuation methodologies, I bring extensive knowledge and practical experience in the field. My background includes in-depth understanding of discounted cash flow (DCF) analysis, a powerful tool used to determine the value of companies or investments based on their expected future cash flows. I've successfully applied DCF models in various contexts, including mergers and acquisitions, investment banking, and business valuation.

Let's delve into the concepts discussed in the article:

Discounted Cash Flow (DCF): Discounted Cash Flow is a financial analysis method used to evaluate the value of a company or investment based on the projected future cash flows. It involves discounting the expected future earnings to determine their present value. The method aims to provide an objective assessment of the intrinsic value of an investment.

Discounted Cash Flow Analysis: This refers to the application of Discounted Cash Flow in determining the value of an investment based on expected future cash flows. The process, along with its associated formulas, is often referred to as the Discounted Cash Flow model.

Pros and Cons of Discounted Cash Flow:

Advantages:

  1. Precision and Detail: DCF analysis utilizes specific figures, incorporating crucial assumptions about a company, including cash flow forecasts, growth rates, and other metrics, resulting in a detailed valuation.
  2. Intrinsic Value Determination: It calculates the value independently of market sentiments, offering objectivity compared to other methods.
  3. No Need for Comparables: DCF analysis doesn't require market value comparison with similar companies, making it versatile.
  4. Long-Term Consideration: It evaluates project or investment revenues over the entire economic life and considers the time value of money.
  5. Objective Comparison: DCF allows for the objective and consistent evaluation of various types of companies or investments.

Disadvantages:

  1. Dependency on Future Projections: DCF heavily relies on forecasts for future cash flows, which can be highly uncertain, leading to potential inaccuracies.
  2. Data Intensiveness: Conducting DCF analysis requires a substantial amount of financial data, making it challenging for some investors to gather the necessary information.
  3. Sensitivity to Estimates: The analysis is sensitive to variables such as future cash flow forecasts, growth rates, and discount rates, making it susceptible to inaccuracies.
  4. Complexity: Due to the data requirements, DCF analysis can become complex, especially for those not well-versed in financial modeling.

When to Use Discounted Cash Flow: Discounted Cash Flow is suitable for valuation in the following scenarios:

  • When cash flow is relatively stable and predictable.
  • In industries with consistent and forecastable operations.
  • For established and stable companies.
  • When assessing potential mergers and acquisitions.
  • In real estate investments.

When Not to Use Discounted Cash Flow: Discounted Cash Flow is less effective in situations where:

  • Future cash flows are variable or unpredictable.
  • Companies have cyclical revenue patterns.
  • Internal evaluation of new products is required.
  • Dealing with private companies or startups.
  • Technology companies with unpredictable initial cash flows.

Determining Discount Rates: The discount rate, a critical component of DCF, includes the Weighted Average Cost of Capital (WACC) and reflects the cost of generating cash flows. The rate is adjusted based on the risk associated with the investment; higher risk leads to a higher discount rate.

In conclusion, while Discounted Cash Flow analysis has its strengths in providing a detailed and objective valuation, it is crucial to recognize its limitations and choose appropriate scenarios for its application. The accuracy of future projections and the careful consideration of discount rates are pivotal in ensuring reliable results.

Advantages and Disadvantages of Discounted Cash Flow | Smartsheet (2024)

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