DCF analysis – the good and bad about choosing it

Talk about the valuation of an investment of any size, DCF analysis is one name that is often recommended. DCF or discounted cash flow analysis is the method in which the company’s value is being perceived on the basis of the actual cash flow that the company is predicted to make in the coming future. When we take any investment be it a small investor investing in a small set of stocks or a large investor or investment firm placing its capital on a new project the intrinsic value of the stock or the project is what matters in the end. DCF analysis helps the investor understand the intrinsic value.


What is DCF analysis?

How would you find if the chosen investment opportunity is really a good one? You should know the actual value of the opportunity, the cash flow it can generate and the growth predicted. Time value of money is something that cannot be underestimated. Even a small amount of cash flow earned in the early days after the investment might matter a lot more than the large cash flow generated in the far future. DCF analysis would take into account not just the cash flow that the investment opportunity yields in the current situation but also the predicted growth. The actual value of the company would not be measured accurately if its current performance alone is taken into account. The same way, to understand and to properly evaluate an investment opportunity the returns that the investor can expect with the time value being taken into consideration should be analyzed. And this is what DCF analysis is all about.

Pros

  • Intrinsic value is the justified measure of an investment opportunity’s value. DCF takes this into account
  • Any volatility in the market, short-term movements might not affect the decisions being taken. Some temporary changes in the market might cause an investment opportunity to generate reduced cash flows. But if there is scope for stabilization and quick rebound then the capital is in a good place.

Cons

  • DCF analysis is known to take a lot of details for making the decision. This makes it a little complicated to use. And this decision might also take time.
  • The analysis made here would be based on some predictions for the future. Such predictions are not always accurate. Smallest changes or even the tiniest detail that is missed out might result in major impacts. So DCF should be done with utmost caution with a reliable source of data.