5 Pros and Cons of Using a DCF Valuation

Discounted Cash Flow (DCF) Valuation is an analysis that finds the value of an investment on the basis of expected future cash flows. It is used in order to assess the potential of a new investment before making a decision. As a result, it predicts and forecasts future cash flows by using a discount rate method. The discounted cash flow valuation is widely used in all the fields, utilities, industries, and institutions that are interested in allocating their funds for long-term projects and investments. This article will discuss the basics and outline some major pros and cons of using the DCF method.

DCF valuation method to value business

DCF valuation method is a tool that uses financial metrics and future cash flows in order to value a business. By valuing the business based on the discounted value of future expected cash flows, it can give a fair market value (FMV).

What is the DCF valuation method?

DCF is a discounted cash flow analysis to estimate the value of an investment based on the projected cash flows. By using the discounted cash flow method, investors and business owners can identify the current market value and then decide whether the company is overvalued or undervalued.

It helps to provide you with the rate of return or discount rate using future projections of cash flows. Thus, when you compare the current market value with the discounted value of future cash flows, you can get a fair value of the company.

Formula of DCF valuation method:

With easy calculation, the DCF method is a straightforward way of valuing a company. Following is the formula:

DCF Formula = [CF1 /(1 +r)1 ] + [CF2 /(1 +r)2] + [CFn /(1 +r)n] Here,

• CF is the cash flow for the given year.
• CF1 for the first year
• CF2 for the second year.
• CFn for additional years.
• r is the discount rate.

While it may not be possible to find the future cash flow for the whole life of a business, With that being said, we project the cash flow for 5-7 years and compare the value with the current price of the business to arrive at a conclusion. Likewise, we should use a discount rate that is consistent and appropriate.

How to value a business with the DCF valuation method?

There are comprehensive valuation models that elaborate the process of valuing a business or entity. While companies can be valued using the DCF approach: to conduct DCF analysis, you need to make assumptions about future cash flows. To do that, you need to study the forecasted sales margins, operating margins, risks, cost of capital, and growth rates. Here are some key points that you should know before doing a DCF valuation method to value a business:

• Free cash flow to the firm - This is a measure of how much cash will remain after accounting for all the cash outflows. Free cash flow to the firm is calculated by subtracting capital expenditures from operating cash flows. Free cash flow is a valid way to measure the return on investment because it measures the amount of cash generated by the business without taking into account any capital expenditures or expansion.

• Present value of explicit free cash flow - You should be aware that this is the measure of how much cash would be generated if you invested the firm's value today. In other words, it is a cash flow going forward (free cash flow) discounted back to the present value. It is crucial to know the present value of explicit FCFF because it helps you assess the firm's value.

• Future value of terminal value - This is a measure of what value will be generated beyond the forecasted period. It is assumed that a company will grow at a rate consistent with the historical growth rate, and then it will reach the terminal value. The future value of terminal value helps to assess the future cash flows and value of a company.

• Present value of terminal value - The expectation that a company will have the same value in the future as at present is called terminal value. In simple words, a stable growth rate forever is assumed and will be used to calculate the present value of the terminal value. Therefore, you will have to create a projection of the future cash flows that cover the forecasted period. You need to be aware of the assumptions and equations used to estimate them. This will help you to make realistic projections and make a sound investment decision.

  
  

Calculation example of DCF valuation

Let'st's apply the DCF method to an example to better understand the method. Assuming that you are planning for a 5-year investment of about $11 million with a discount rate of 5%. Following are the values expected from the cash flows.

Year 1: Cash Flow = $1 million, Discounted Cash Flow = $952,381

Year 2: Cash Flow = $1 million, Discounted Cash Flow = 907,029

Year 3: Cash Flow = $4 million, Discounted Cash Flow = $3,455,350

Year 4: Cash Flow = $4 million, Discounted Cash Flow = $3,290,810

Year 5: Cash Flow = $6 million, Discounted Cash Flow = $4,701,157

Here, you can see that you have used the same discount rate across all the years while calculating the future cash flows. If you add up all the discounted cash flows, it will be equal to $13,306,727.

As mentioned above, the initial value of $11,000,000 should be subtracted from the sum of discounted cash flows of $13,306,727 to decide whether you should invest in the company - this resulting net present value of $2,306,727, which is a positive value for your investment. Therefore, a positive value discounted cash flow shows that the investment is worth it at fair value.

The DCF calculator enables you to quickly and easily enter the relevant information about a business and then use it for valuation. There are different tools that help to perform similar tasks. Such tools are useful when you want to save time and money.

Pros and cons of DCF valuation method

Now that we know how to do DCF valuation, let's take a look at the pros and cons of the DCF method.

Pros of the DCF method

Here is some key importance of the DCF valuation method:

• Use all the details - The major advantage of discounted cash flow is that it helps you to arrive at the value of a company by using a wide range of information like cost, revenue, expenses, and other financial details. It helps investors to figure out the value of a business accurately. Overall, the DCF valuation method helps you get diverse information, which is very helpful in finding the company's true value.
• Calculate intrinsic value - The DCF approach is one of the most popular methods used to calculate intrinsic value. Intrinsic value is the true value of a business or investment that you can make. The DCF method is highly effective in calculating intrinsic value. However, you need to find the right growth rate and discount rate for your investment before moving forward.
• Long-term value - The discounted cash flow method helps investors in estimating the long-term value of an investment. It is a good technique to find out the future value of a business or investment to help in determining whether an investment is a good idea. The DCF valuation method also helps investors to identify the factors that are key to the company's long-term growth.
• Can be used to compare objectives - This technique is used to compare the different objectives of companies. The approach helps you to evaluate the company's ability to achieve different goals. The in-depth analysis of DCF provides you with a better understanding of the objective over which a particular company has planned. This helps you to create an effective plan for a business.
• Help in M&A activity - If a company decides to merge with another, it can use the DCF method to determine the target company's fair value in the process. The approach helps in estimating the fair value of a business when acquiring or merging with another firm. It is also used extensively by investment bankers and valuation professionals while figuring out the price of an acquisition and merger between two firms.
• Calculation of internal rate of return - The DCF method is used extensively in calculating the internal rate of return (IRR). The IRR is the major figure used in evaluating the cash flow of a project. It helps you to estimate the return based on a given time period. When an investment has multiple cash flows, and IRR is calculated for each of those, it will help you estimate the project's total return.
• Allow deep analysis - The discounted cash flow method allows investors to properly understand the company. It helps to provide a better understanding of the business and helps you figure out the business's true performance. This technique helps you to analyze the cash flows for each year and then arrive at the company's future value.

Cons of the DCF method

On the downside, there are some drawbacks that have to be considered while using the DCF valuation method. The following are the few shortcomings of DCF valuation.

• Requires consequential data - As mentioned earlier, DCF valuation requires consecutive values of future cash flows. The limitation is that if you are looking for a cash flow before the next year, then you need to assume that value. In some cases, the assumption might prove to be wrong. The result will affect your business valuation, and you may need to re-examine your assumptions.
• Sensitive to variables - The major limitation of DCF valuation is that it doesn't take into consideration all the variables. You need to make a number of assumptions depending on the particular business, its growth rate, and other factors. This can lead to inaccurate results because there are multiple unknowns before you arrive at the right conclusion. These factors are sensitive and can affect the outcome of the entire analysis.
• Analysis requires accuracy - When you are looking for the best possible assumptions, you should check your assumptions' accuracy. You will be required to find out the true value of a company. The analysis requires accuracy, and you will also need to check whether your assumptions are correct; then, it can prove beneficial for all involved in valuation.
• Require high confidence in future cash flow - The DCF approach highly depends on future cash flow. An investor will have to make a number of assumptions about the future of a business and its cash flows. You need to make some predictions about the future of the business for doing DCF valuation. Overall, the DCF method is highly dependent on future cash flows. These assumptions also need to be entered into all the accounts, and it needs to be checked whether they are correct.
• Complex - The DCF method is considered to be complex because of the assumptions involved. The approach is also sensitive to variables, and the results can be affected accordingly. Once you are done with all the processes, you will need to ensure that the final numbers are accurate enough for a business valuation. This can be a great issue to consider before applying the DCF valuation method.
• Not helpful to value competitors - The DCF is not helpful when it comes to comparing value between different businesses. Competitors may have different growth patterns, and the DCF method is not helpful in comparing those different patterns. It is highly useful when it comes to determining the value of a single business. When it comes to comparing two companies, this technique may not work well.
• Terminal value challenge might be there - When performing DCF valuation, you need to consider the terminal value. It is a challenge to determine the terminal value because it involves considering future cash flows in the long term. It might turn out to be a challenge to determine the future growth rate and other factors, making it difficult to determine the terminal value.
• Difficult to calculate WACC - The weighted average cost of capital (WACC) is the required percentage for finding out the discount rate. It can be hard to calculate the WACC when you are using the DCF valuation method. WACC includes the average rate of return that shareholders expect from the company.
• Not adaptable for different sizes of investments - The DCF method requires certain assumptions to be made depending on the size of the investment. When you have multiple investments, you cannot utilize the same approach for each of them because different assumptions will be needed.

To sum up, the discounted cash flow method is widely used in the field of business valuation. The DCF method is used extensively in valuing different projects, companies, and other investments. Using this method allows investors to better understand the business and helps arrive at the true value of a company. With the right assumptions and high confidence, you can achieve the best result from this valuation method. There are certain advantages and disadvantages associated with the DCF valuation method: you need to consider all the aspects before utilizing this approach for business valuation.