Hazards of the Future and Limitations of DCF

Hazards of the future and limitations of DCF

The process of estimation and discounting is intended to recognize the hazards of the future by incorporating into the cash flow estimates the onslaughts of:

• competition,
• technology,
• patent expiration,
• deregulation,
• globalization, and
• other upheaval.

This entails close examination of factors such as sales, margins, and cap-ex.

Likewise, the discount rate is intended to capture the effects on capital costs of:

• long-term financing markets,
• lender appetites for the company’s securities, and all such underlying risks.

But all these variables are by definition unknown, uncertain, and difficult to quantify. In the math, moreover, tiny differences in the assumptions drive substantial differences in resulting valuations.

Among the largest component of resulting value in this model is the value assigned to the horizon (the perpetuity piece beyond the 5- or 10-year mark). Its derivation is a function of assumed growth rate and assumed cost of capital. At estimates of 5 percent and 10 percent, as noted, the multiple is 20; tweak these and enormous ranges emerge.

Even so, the discounted cash flow valuation model is the most widespread model in contemporary valuation.

• Some value investors use it, at least in part.
• Others eschew it entirely.

Both groups look instead to assets and earnings measures deemed more reliable than cash flows to come to grips with valuation.


Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF