While the discount cash flow model is still the most reliable and used business valuation method, it falls short when it comes to accurately predict and discounting future cash flows. It may be the best way to value stocks, but it also has a few shortcomings that investors should be aware of.
In this article, we will discuss step by step the reasons why the DCF is unreliable and should be used only as a framework and reference for stock valuations.
What is the discounted cash flow model?
The Discounted Cash Flow or DCF model is a valuation technique or method that is based on estimating the value of an investment by calculating its future cash flows and discounting it with a discount rate.
The logic behind it is that the present value of every investment should be calculated based on its future cash flows. Still, because these cash flows will only be received in the future, they have to be discounted to consider the value of the money, the risk level, and the opportunity cost of pursuing other investments.
Future cash flows are anticipated and discounted in DCF using a discount rate. While there are a few theories on what discount rate should be based on the type of company or investment, as a rule of thumb, you want to discount the future cash flows based on the expected return of similar investments.
The discount rate considers the projected return on other investments with comparable risks, as well as the risk associated with the investment under consideration. In investing, the DCF can be used to value stocks, real estate, and other investments.
It is also useful for assessing capital expenditures and other financial metrics that help investors make investment decisions. The accuracy of a DCF valuation model, however, is strongly dependent on the accuracy of the predicted future cash flows and the discount rate used, as well as the assumptions built into it.
Discount cash flow model assumptions
While the discount cash flow model is still the most important valuation tool investors have at their disposal, it has plenty of shortcomings, limitations, and disadvantages because it is based on assumptions.
For an investor to calculate the present value of future cash flows, it has to make assumptions about what those cash flows will be. Additionally, it also has to assume the growth rate of those same cash flows, and while it may seem simple, it is very difficult to make accurate predictions of this sort.
Because it is solely based on estimates and projections, this is the main limitation and disadvantage of using the DCF model.
11 Reasons why the DCF is unreliable
1. Subjective Approach
First, the DCF method may seem like a highly analytical and logical approach to valuation. Still, it is, after all, just a subjective approach that tries to simplify assumptions and expectations relative to a company’s financial performance. This is a very subjective endeavor. When investors try to predict future cash flows, they are extremely prone to errors and biases that may cloud their judgment and influence their projections.
If future cash flow estimates are made with a high level of detail, the DCF method for valuing equities can lead to overconfidence. The more comprehensive the projections, the more confident the ensuing valuation, and it could simply be a way for investors to showcase their confirmation bias. While being confident in your investing assumptions is important, you want to avoid overconfidence.
This confidence might be deceptive because the accuracy of a DCF valuation is strongly dependent on the precision of the inputs and assumptions used. It is critical to understand that the future cash flows employed in a DCF technique are inherently uncertain and that even small errors in forecasts can lead to major flaws in the final value.
Overreliance on detailed projections might result in a false sense of assurance and inaccurate valuations. A high degree of detail in the projections can be time-consuming and resource-intensive, and it may not produce a considerable boost in the valuation's accuracy.
It is critical to achieving a balance between the level of detail in the projections and the time and resources required to develop them.
3. Hard to predict an accurate discount rate
Not only are investors predicting future cash flows and their growth rate, but they are also trying to estimate the right discount rate to justify the investment. One of the difficulties in applying the Discounted Cash Flow (DCF) approach for stock valuation is effectively predicting the Weighted Average Cost of Capital (WACC).
The WACC is typically used as the discount rate, and it is an important input into the DCF model since it is used to calculate the present value of a company's future cash flows. The discount rate employed in DCF is an important aspect of estimating the present value of future cash flows.
An inaccurate rate can have a major impact on a stock's valuation. Estimating the WACC requires a full understanding of the company's capital structure, debt and equity costs, and the risk associated with each form of funding, as well as the knowledge of similar companies in that industry or sector.
Furthermore, the WACC must be adjusted to represent the specific risk of the firm being valued. It is subject to change over time as the financial profile and market conditions of the company change.
4. Ignores competitors
The DCF method focuses on a stock's intrinsic value based on its own financial performance and future cash flows rather than its competitors' relative valuations. This indicates that even if a company's intrinsic value is correct according to the DCF model, it may be undervalued or overvalued compared to its peers.
Additionally, if you are valuing just one stock in a single sector, it might not give investors the full picture of the possible returns and growth rates of competing businesses.
5. Terminal value is hard to predict
The terminal value in DCF represents all future cash flows after the forecast period. This value is very subjective and has a major influence on the ultimate valuation. The terminal value is an important component of the DCF model and accounts for much of a company's overall value.
Accurately determining the terminal value necessitates a detailed understanding of the company's financial profile and market conditions, as well as a rigorous and well-documented technique for evaluating the growth rate and discount rate.
6. Assumptions-based technique
As we mentioned, the DCF’s main limitation is the fact that it is solely based on assumptions, such as growth rates, reinvestment rates, and margins, which can be difficult to calculate and have a significant impact on the final valuation.
7. Ignores unforeseen events
The discount cash flow model does not account for events that can have a significant impact on a company's financial performance but are difficult to predict, such as a recession, a pandemic, a market crash, or a big technological disruption.
For example, the pandemic was a completely unforeseen event that rendered almost every DCF model useless. This serves as an example that the future is hard to predict, and assumptions made today may not materialize in the future.
The discount cash flow model is also an extremely time-consuming and difficult process that necessitates comprehensive financial estimates and a thorough understanding of the investment being assessed. Additionally, any material event requires analysts or investors to update and constantly tweak their models to reflect the current environment, which makes it even more challenging.
9. Ignores non-financial factors
Since it focuses entirely on the company's financial performance and does not consider non-financial factors affecting the stock price, such as management quality or brand awareness.
It also does not evaluate the business reality in the sector or industry, which may change abruptly.
10. Ignores market trends
The DCF simply calculates the present value of future cash flows to value investments, and this means that some market trends that may impact stock prices are not considered in the model. Investor sentiment drives prices either up or down, and the DCF model cannot compute how trends and sentiment can influence stock prices.
This figure does not consider all of the elements that can influence the value of an investment, such as market trends and the competitive climate.
11. Less valuable for startups
When valuing startups or early-stage companies, the DCF is pretty much useless. Since there is so much uncertainty about growth rates, margins, and even the discount rate, valuing startups using this method is unreliable.
The DCF is better suited to established companies with a track record of predictable cash flows, making it less useful for startups and early-stage enterprises with minimal financial data.
Why would you not use a DCF in a valuation?
The DCF is still a popular financial tool for evaluating assets, particularly for established businesses with consistent cash flows and a track record of financial performance. Moreover, it is still the best way to analytically try to come up with a stock valuation that actually makes sense.
But like any other valuation method, it has limitations and is dependent on the assumptions made. The DCF can be particularly difficult to apply to early-stage companies or those with very unclear future cash flows, where other valuation methodologies, such as comparable company analysis or market multiples, may be more suitable.
While DCF is a useful tool for valuation, it should be used in conjunction with other valuation methodologies and should not be relied on completely. It is crucial to remember that the stock market is influenced by variables other than a company's financial success, such as macroeconomic conditions, investor sentiment, and overall market performance. Considering these aspects might provide a complete picture of a stock's value.
The best way to use the DCF model
While the discount cash flow model has clear limitations, there are still ways that it can be used, and when used correctly, it can pretty much paint any possible scenario. Most investors tend to focus on predicting what can happen in the future in a somewhat binary way. Either something good happens, or something bad happens. In reality, there are all sorts of scenarios and possibilities, and a single DCF model does not contemplate all of them.
To use the DCF model in the best way possible, you will have to use several DCF models. This means making assumptions on all the possible scenarios and then calculating the present value of the stock.
Let’s say the average assumption is that the company will grow its cash flows at 5% a year. Why not build 4 different models, where the growth rate is -5% on one, 0% on the other, 5% on the main one, and lastly, 10%. By doing so, you are discounting the future cash flows based on the most likely scenarios, giving you a better idea of the value of the stock.
If the present value of the stock is still higher in most of the scenarios, this may provide a margin of safety to your investment, and it gives you a fuller picture of what can happen to the company.
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