The Limitations of the Discounted Cash Flow Method
The Discounted Cash Flow (DCF) valuation is one of the most utilized tools for business valuation that is used by investors and small business owners due to its detailed and meticulous approach, and considers different factors in the evaluation. The DCF is computed by discounting the future cash flows using the discount rate to derive the net present value. The Weighted Average Cost of Capital mostly uses a discount rate as it considers the weighted cost of equity and debt.
However, DCF valuation also has its share of limitations. Since this method includes many projections, including the future cash flows and the computation of the discount rate, it can be inaccurate if the assumptions are too optimistic or do not consider all factors involving risks. That's why the DCF approach needs expertise in its usage to derive the result that reflects a useful representation of the business valuation. Some of the significant limitations of the DCF method are presented below.
1. Projecting Future Cash Flows. Expecting how much free cash flows you will have in the future can be inaccurate since many unforeseen factors can occur primarily if the projection is longer. The forecast for the 1st year to 2nd year can be closed to the actual since you have recent data to base it from. However, projecting way beyond can include more margin of error.
2. Calculating the Discount Rate. A little change in the discount rate can have a significant impact on the projection. The Weighted Average of Cost Capital (WACC) used to discount the future cash flows, which means that a mistake in computing for the WACC can produce enormous changes in the result. Computing for the cost of debt might be secure since you base it on the interest charged for the loan. However, the cost of equity has a lot of assumptions to make. The computation for the cost of equity includes the risk-free rate (usually based on the government-issued instruments), market-risk premium, and the beta (the covariance of a stock's return against the overall market). By just computing the cost of equity, it already challenged the accuracy of the result since it involves so many factors.
3. Terminal Value. There are two ways to compute for the terminal value, which are the perpetual growth method and the terminal exit method.
a. Perpetual Growth Method. This method assumed that the business would grow at some constant rate into perpetuity, which poses the question of how you will be able to come up with the amount that would measure that infinite duration.
b. Terminal Exit Method. This approach is computed by multiplying the financial statistics (commonly EBITDA) to the multiple applied by recently acquired relative firms. The usage of EBITDA is also uncertain, which can project doubt to the approach.
This article is not to discourage the use of DCF valuation, which is, in fact, one of the trusted business valuations. Instead, this is to scrutinize its weak spots to be careful in making the necessary assumptions. It is also advisable to use other valuation methods to build a strong foundation for the decision-making process. eFinancialModels offers financial model templates that incorporate different valuation methods into the business model fitted for various specific industries.