A Critical Evaluation of the Discounted Cash Flow Valuation Method

This essay provides a critical evaluation of the Discounted Cash Flow (DCF) valuation method, which estimates the intrinsic value of an asset or business based on its fundamentals and expected future cash flows. The analysis highlights the advantages of DCF, including its reliance on fundamental drivers like equity costs, growth rate, and weighted average cost of capital, as well as its use of free cash flows to eliminate subjective accounting policies. It also notes the model's ability to incorporate changes in business strategy. However, the essay also discusses the disadvantages of DCF, such as its sensitivity to assumptions about discount and growth rates, its limited applicability when future cash flows are uncertain, and the significant impact of terminal value assumptions on the final valuation. The essay concludes by noting that the DCF model, with its focus on long-term value creation, is not suitable for short-term investing.

Running head: DISCOUNTED CASH FLOW
Discounted Cash Flow
Name of the Student
Name of the University
Author Note

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DISCOUNTED CASH FLOW
Critical Evaluation of the method of Discounted cash flow for valuation of the all asset
classes
The Discounted Cash Flow Valuation estimates the intrinsic value of an asset of a
business based upon its fundamentals (Wu et al. 2016). The intrinsic value helps to estimate the
present value of the flow of cash that is expected to be paid to the company’s stakeholders.
The Valuation of Discounted Cash Flow is based upon the company’s future cash flows
that is expected and the rate of discount associated with it. It is the measurement of the risk
attached to the company in particular (Chen and Teng 2015). While critically analyzing the
procedure of valuation the various advantages and disadvantages of Discounted Cash Flow are as
follows:
Advantages:
1. Valuation of DCF captures truly the fundamental drivers underlying, in the business,
which are the equity costs, rate of growth, weighted average cost of capital and the rate of
investment. As a result, this helps in to estimate asset intrinsic value.
2. The discounted cash flow relies on Free Cash Flows unlike other valuations. In a greater
extent, the Free Cash Flows are a suitable measure that helps in eliminating the subjective
policies of accounting and window dressing involved in reported earnings. Irrespective of
whether an outlay of cash is marked as an operating expense in P&L or it will be
capitalized as an asset in the balance sheet. The FCF is a accurate measure of the money
that is left for the investors (Titman and Martin 2014).

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3. Discounted Cash Flow also allows investors to incorporate the various changes in the
strategy of the business in the valuation model that can go unreflected in other valuation
models like relative, APV otherwise.
4. The prediction by DCF is the best possible intrinsic value. Whereas the other methods
like relative valuation becomes questionable when the entire sector or market is under-
valued or over-valued.
5. The most important advantage of DCF model is that, it can be used as a sanity check. The
current share price of the company can be plugged into the model instead of estimating
the fair intrinsic value, and working backwards (Chen and Teng 2015). The DCF model
will represent how much the stock of the company is under-valued or over-valued and
whether there is any justification of the current stock price or not.
Disadvantage:
1. The Valuation of DCF is extremely sensitive when it comes to the assumptions that
related to constant discount rate and the growth rate (Christersson, Vimpari and Junnila,
2015). If any minor shift or miscalculation occurs, and the Value of the DCF will wildly
fluctuate and the fair value will not be accurate.
2. The DCF works best only when there is a high degree of confidence about future cash
flows. However, if the operations of the organization lacks in visibility, it becomes
difficult for sales prediction, capital investment and the operating expenses with
certainty (Wu et al. 2016).
3. Another criticism is the terminal value that comprises of far too much of the total value
(65-75%). Even in case of a slight assumptions variation, the terminal year can have a
great affect impact on the final valuation (Titman and Martin 2014).

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4. Focuses of the model of DCF on long-term value creation it is not suitable for investing
in short-term.
References
Chen, S.C. and Teng, J.T., 2015. Inventory and credit decisions for time-varying deteriorating
items with up-stream and down-stream trade credit financing by discounted cash flow
analysis. European Journal of Operational Research, 243(2), pp.566-575.
Christersson, M., Vimpari, J. and Junnila, S., 2015. Assessment of financial potential of real
estate energy efficiency investments–a discounted cash flow approach. Sustainable Cities and
Society, 18, pp.66-73.
Titman, S. and Martin, J.D., 2014. Valuation. Pearson Higher Ed.
Wu, J., Al-Khateeb, F.B., Teng, J.T. and Cárdenas-Barrón, L.E., 2016. Inventory models for
deteriorating items with maximum lifetime under downstream partial trade credits to credit-risk
customers by discounted cash-flow analysis. International Journal of Production
Economics, 171, pp.105-115.