Why DCF Method is best for valuation and its demerits

The discounted cash flow (DCF) method is a commonly used valuation method that involves estimating the future cash flows generated by a security and discounting them back to the present value using a discount rate. This method is considered to be one of the best methods for valuation due to several reasons:

Focuses on future cash flows: The DCF method focuses on estimating the future cash flows generated by a security, which is an important consideration for investors. This method considers the time value of money, which means that cash flows expected to be received in the future are worth less than cash flows received today.

Incorporates risk: The DCF method incorporates risk into the valuation process by using a discount rate that reflects the risk associated with the security. The higher the risk, the higher the discount rate, and the lower the present value of the future cash flows. 

Flexibility: The DCF method is a flexible valuation method that can be used to value different types of securities such as stocks, bonds, and real estate.

Despite its advantages, the DCF method has some limitations or demerits that investors should be aware of: 

Requires assumptions: The DCF method requires several assumptions to be made such as the growth rate of cash flows, discount rate, and terminal value. These assumptions may not always be accurate, and any errors in the assumptions can lead to inaccurate valuations. 

Sensitive to inputs: The DCF method is sensitive to inputs, which means that small changes in assumptions can lead to significant changes in the valuation. This sensitivity can make the DCF method unreliable if the inputs are not accurately estimated. 

Does not account for market sentiment: The DCF method is based on cash flows and does not account for market sentiment, which can significantly influence the value of a security. Market sentiment can cause the price of a security to deviate from its fundamental value, which means that the DCF method may not always provide an accurate valuation. 

In conclusion, the DCF method is considered to be one of the best valuation methods due to its focus on future cash flows, incorporation of risk, and flexibility. However, it has some limitations such as the need for assumptions, sensitivity to inputs, and lack of accounting for market sentiment. 

Investors should use the DCF method along with other valuation methods and exercise caution while making investment decisions. When using the discounted cash flow (DCF) method for valuation, there are several factors that need to be considered and carefully analyzed to ensure an accurate valuation. Here are some of the key factors to focus on: 

Cash flows: The DCF method relies on estimating future cash flows generated by the security being valued. The analyst must carefully consider the expected amount and timing of cash flows. Cash flows can be influenced by factors such as economic conditions, industry trends, and company-specific factors such as investments in capital projects, acquisitions, or changes in dividend policy. 

Growth rate: The expected growth rate of cash flows is a critical input in the DCF model. Analysts need to carefully consider the expected growth rate and the reasons behind it. For example, a company may have a new product launch that is expected to increase revenue and cash flows, or a company may be operating in a high-growth industry. 

Discount rate: The discount rate is used to determine the present value of the future cash flows. It is a reflection of the risk associated with the security being valued. The discount rate can be influenced by factors such as interest rates, economic conditions, and the risk profile of the company. It is important to carefully consider the appropriate discount rate to use in the DCF calculation. 

Terminal value: The DCF method assumes that cash flows will continue indefinitely into the future. However, it is not practical to forecast cash flows indefinitely. Therefore, the DCF method typically uses a terminal value to estimate the cash flows beyond the forecast period. The analyst needs to carefully consider the assumptions underlying the terminal value calculation. 

Sensitivity analysis: The DCF method is sensitive to the inputs used in the calculation. Small changes in assumptions can lead to significant changes in the estimated value of the security. It is important to perform sensitivity analysis to understand the impact of changes in the inputs on the estimated value. This can help identify key drivers of the value and highlight areas of uncertainty. 

In summary, the DCF method requires careful consideration of a range of factors including cash flows, growth rate, discount rate, terminal value, and sensitivity analysis. It is important to perform rigorous analysis of these factors to ensure an accurate valuation.