Discounted cash flow method – pros and cons

Just about any valuation project is likely to involve the discounted cash flow method. The company value is estimated based on its expected future cash flows and risk. You can use the discounted cash flow analysis to value not just businesses but other income producing assets such as stocks, real estate, projects and much more. Here are the key benefits of the method:

It focuses on the so-called intrinsic value of the company as opposed to its potential selling price in the market. This helps you remove the uncertainty associated with transient factors and sentiment of market participants.

The method allows you to compare different businesses side by side by considering their anticipated cash flows and risk profiles. You can also create different scenarios for the same company, each with its own cash flow forecast, discount rate, and earnings growth rate.  Crunching the numbers let you see how each scenario affects business value.

If you are thinking of investing in a business, running a discounted cash flow valuation helps you spot undervalued target companies and steer clear of overpriced ones.

Beware of the gotchas

At the same time, the discounted cash flow valuation is not without challenges:

The value result you get depends on your cash flow forecast and assumptions about future earnings growth rates, terminal value and discount rates. There is always a possibility that some of these factors may be off.

Depending on your valuation scenario, some inputs may have significant impact on the result you get. For example, overestimating the earnings growth rate can overstate the terminal value and the final business value result. The result you get also depends on your cash flow forecast, especially the early years. Be sure your discount rate matches the company’s risk profile. If the discount rate is too high, the business value is likely to be lower than expected. Conversely, underestimating the risk leads to an overly optimistic valuation.

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