Being one of the most widely used methods of valuation, it will be worth our while to examine the pros and cons of this method.
DCF is arguably the most sound method of valuation as it calculates the closest intrinsic value of the company. It is a forward-looking approach which depends more on future expectations rather than historical results.
It is influenced to a lesser extent by volatile external factors because it is an inward looking process which relies more on the fundamental expectations of the business and explicit estimates of the value drivers. Unlike relative valuation methodology, it is less affected by the accounting practices and assumptions because it is focused on cash flow generation.
In addition to explicitly considering the drivers of value creation, the DCF allows analysts to incorporate business strategy changes into the valuation. For example, a company might implement a new cost cutting program designed to drive margins higher over time. If the investor anticipates that the new program will be a success, she can factor the margin increases into future cash flow estimates.
Clearly, there is a lot to like about this valuation tool. However, there are also reasons to be cautious about it.
The accuracy of the valuation determined using the DCF method is highly dependent on the quality of the assumptions regarding Free Cash Flows, Terminal Value, and Discount rate. The value derived is highly sensitive to the inputs used, leading to wildly different valuations by different analysts based on their subjective judgment of the future prospects of the company.
The Terminal Value (TV) often represents a large percentage of the total value derived through DCF, causing the Enterprise Value to be largely dependent on TV assumptions rather than operating assumptions for the business.
DCF works best when there is a high degree of confidence about future cash flows. But things can get tricky when it’s difficult to predict future cash flow trends. Owing to this, it is not considered prudent to value early stage enterprises using this methodology.
When or When Not To Use
To conclude, the DCF is a very useful tool, provided that its constraints are clearly understood and it is used in conjunction with other tools like Relative Valuation as a sanity check. The DCF provides the most reliable intrinsic value when the company operations are very stable and future cash flows be predicted with certainty. It should not be applied to early stage companies as its operations are still at a nascent stage and lack “visibility” ,that is, it’s difficult to predict revenue and cost trends with much certainty.