Introduction
In the valuing the business, you have various kinds of valuation methods that business valuers in India offer. And one such valuation method is the Discounted Cash Flow (DCF) model valuation that calculates investments in your business as per the expected future cash flows and discounts on the current value at the required discount rate.
DCF valuation method is used in calculating the integral value of a business according to an investment's worth with a realistic and future-focused perspective. If you are considering the DCF model for valuing your business, then this blog is just for you.
Here we are discussing the advantages and disadvantages of DCF method of valuation to help you choose the right method for your business valuation.
Let’s begin!
DCF Method of Valuation
The discounted cash flow (DCF) model is a valuation method for company finances that assesses the value of a business, assets and projects by measuring the current value of expected future cash flows.
DCF method of valuation is a popular business valuation approach in finances that calculates the intrinsic value of a business, asset, or project. The DCF model primarily calculates the present value of expected future cash flows.
By considering that the value of a business asset is profoundly the total of its near future cash flows, the DCF model discounts backs to the asset’s present value by using an appropriate discount rate.
Let's talk about the advantages of DCF valuation method first.
DCF Valuation Method Advantages
The DCF valuation model is preferred because of its multifaceted approach that focuses on intrinsic value of the business and provides a definitive valuation by depending on free cash flow and its comprehensive and adaptable method.
The DCF valuation method is future oriented and assesses the future potential of the business while providing the exemption from market variations. Similarly, the reverse DCF method offers a distinctive point of view on valuation accuracy.
Here are advantages that show why DCF valuation method is popular among investors to get a company's correct value.
1. Independent Valuation Method
The DCF method is a reliable way of evaluating your business, with future cash flow estimation and their adjustment to present value via discounting. The DCF method offers investors the chance to define a company's worth without being influenced by market changes or subjective opinions. It totally relies on solid assessments of revenue growth, profit, and cash flow.
DCF method helps you understand that future money is worth less than money today (time value of money) and gives the valuation, representing the company's earning potential. It is useful especially for investors looking to determine the real value of their investment in any company.
2. Free Cash Flow Dependency
Because of dependence on free cash flows (FCF), the DCF valuation method gets accurate and trustworthy estimates about company finances. DCF method dismisses the biases of accounting rules and the risk of altering reported earnings.
The cash available to investors is portrayed accurately by FCF, regardless of how expenses are categorized in the income statement or how assets are listed on the balance sheet. That’s why, by focusing on actual cash flows, DCF valuation model provides you with a reliable valuation of a company, giving your investors a trustworthy basis for their analysis.
3. Detailed and Adaptable
The DCF valuation model is popular for giving a detailed view of a company's value, calculating on expected cash flows. It is quite helpful to investors who are dependable in their forecasts, giving them estimates of the company's profit potential, market position, future growth, expenses, and risks.
The DCF valuation method ensures a detailed assessment of the business’s true value by taking into account all significant aspects of the business. As the DCF model is highly adaptable, it enables investors to adjust the method as per different scenarios and assumptions.
The adaptability of DCF method is useful for evaluations across various industries, accepting changes in growth rates, discount rates, and cash flow projections. The DCF method also supports sensitivity analysis on how changes in assumptions impact the company's value.
4. Future-Oriented
Generally, the DCF model looks upward and shows the importance of future cash flows instead of previous or current results. The DCF approach requires evaluation of the cash flows a company is expected to generate to give investors an overview of the anticipated performance of an asset.
The DCF method concentrates on future opportunities and proves an appropriate reference for long-term investors by considering all expected results for a business. It shifts the focus to measuring the present value of the future cash flows and provides a perspective centered on the future potential of a company.
5. Market Autonomy
The DCF model provides a more accurate evaluation of a company's true value, since it’s safe from short-term market changes and external factors that normally interfere with other valuation methods. Due to independence from the market, it ensures that current stock prices do not affect the assessment by focusing solely on the company's real worth.
Moreover, the DCF method is particularly useful in difficult company comparisons, like when there are no direct competitors or limited similar deals. Its ability to operate without needing comparisons to other firms makes it possible for a detailed analysis even when relevant market information is lacking, making it a helpful method for calculating a company's genuine value, free from market volatility.6. Reverse DCF Model
The DCF model is also useful for investors to evaluate the value of a company. By using the current stock price in the model and looking at it from a different perspective, investors can find out if the shares are priced too high or too low.
The reverse DCF method explores the reasoning behind the current stock price and compares it to the expected cash flows of the company. It helps investors judge their investment decisions, ensuring that the market value aligns with financial estimates.
DCF Valuation Method Disadvantages
The DCF model is helpful for evaluating intrinsic value, but it also has some limitations and disadvantages that you can’t ignore. These include potential errors, complexity of valuing, sensitivity to assumptions, and uncertainties about the future that can affect end valuation.
It also does not consider competitor analysis, can make it hard to find the weighted average cost of capital (WACC) and assess terminal value, and requires a lot of time and expertise.
After discussing the pros, here are the cons of DCF valuation method:
1. Errors and Excessive Complexity
The accuracy of the DCF valuation method relies on having correct and timely information. If you get errors in input information such as revenue forecasts, discount rates, or terminal values, it can lead to wrong valuations, especially in highly dynamic and uncertain industries.
The need for large amounts of data and complex calculations increases the chance of mistakes and makes the process complicated and resistant to errors. Even relying on specific assumptions about forthcoming financial results can create overconfidence among investors, which might hide the inherent uncertainty in future predictions. This shows the speculative nature of DCF valuation method.
2. Hypothetical Result Insensitivity
The DCF valuation model has a major limitation due to its heavy dependence on assumptions. Even small changes in assumptions can greatly affect the valuation. The sensitivity of hypothetical results links the accuracy of the method to the quality of financial predictions after getting poor input.
For newly formed companies with little previous data, making accurate forecasts by DCF valuation method is challenging. It is also hard to predict sales, operating costs, and capital expenses, especially for businesses with unpredictable operations.
The need for many assumptions about cash flow, discount rates, and growth rates adds to the variability. The DCF valuation method’s dependence on accurate long-term projections challenges the reliability and the need for careful use.
3. Future Uncertainty
As the DCF method mainly relies on estimating future cash flows, it may be unpredictable due to outside factors and market conditions. Even small errors in the predictions can severely impact the valuation, as noted before.
That’s why the DCF valuation model works best when there is a strong certainty about future cash flows, highlighting its sensitivity to forecasting challenges and the unpredictable nature of business.
4. Terminal Value Impact
Terminal value in DCF model represents 65-75% of the total valuation. Therefore, it is crucial since minor adjustments in terminal year assumptions can significantly impact the valuation result.
Estimating terminal value requires long-term cash flow forecasts, involving calculated predictions about growth rates and other factors. However, due to the uncertainty of future financial conditions, it can be challenging.
5. Fixed Capital Structure
One of the major drawbacks of the DCF valuation method is its assumption that a company’s capital structure remains constant over time.
In reality, companies usually change their balance of debt and equity as they grow. Considering these changes when going for DCF valuation model is difficult because the growth in debt varies across companies and industries.
At the same time identifying an optimal capital structure involves subjectivity which adds complexity to the model, making it harder to accurately reflect a company's future financial structure in the DCF valuation.
6. Lack of Competitor Comparisons
The DCF method evaluates a company's value independently, concentrating on financial metrics and future cash flows, while ignoring competitive comparisons. This can minimize key factors like market sentiment and investor behavior, which are crucial for asset valuation, especially in the stock market.
While DCF valuation method may accurately reflect the true value of an individual business, it doesn’t capture the market price affected by qualitative elements. Also, it isn't made for comparing values across different companies, failing to account for varying growth trends in competitive sectors.
7. Limited Applicability
The DCF model, like many valuation methods, it isn't always the perfect choice, especially for assets with unstable cash flows or industries with unpredictable cash flow patterns.
The DCF valuation is not suitable for evaluating companies in banking and finance due to their unique cash flow specifications and regulatory conditions. This limitation highlights the challenges of using the DCF model to accurately assess the value of investments that do not fit the model's preference for steady and predictable cash flows.
8. WACC Complexities and Flaws
The DCF model has the difficulty of calculating the Weighted Average Cost of Capital (WACC), commonly used as the discount rate in DCF valuations. The WACC displays the return investors expect by measuring the costs of equity (common and preferred) and debt.
The WACC is complex because of the variety of components in the capital structure, each with different estimation methods. To overcome this limitation, investors can use alternative discount rates, such as their own required rate of return, instead of solely relying on WACC.
9. Complexity and Time Consuming
The DCF model is multilayered and time-consuming, presenting more challenges than other valuation methods. Calculating future performance is crucial, but it requires a deep understanding of the business and market trends.
The complexity arises from the need for detailed financial data and complicated calculations, creating difficulties for businesses with less financial background. The method relies on numerous assumptions about future revenue and costs, making it sensitive to changes and requiring detailed validation to reflect the business's true value.
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Bottom Line
Now, you can estimate the role of the DCF valuation method with its pros and cons. The DCF method of valuation is useful at the same time shows drawbacks for the companies that have inaccurate base data or are just starting off their business in the market.
That’s why choosing the right valuation method with the right business valuer is so important.
As one of the best business valuation firms in India, our team of IBBI registered valuers provide industry proven valuations including business valuation, startup valuation, ESOP valuation, etc.
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