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https://corporatefinanceinstitute.com/resources/knowledge/valuation/dcf-pros-and-cons/

Pros and Cons of DCF Analysis

What are the Pros of DCF analysis?

It would be best for a financial analyst to use the DCF analysis if they are confident about the assumptions being made. A discounted cash flow model requires a lot of detail to make an estimate of the intrinsic value of a stock, and each of those details requires an assumption.

The main Pros of a DCF model are:

Extremely detailed

Includes all major assumptions about the business

Determines the “intrinsic” value of a business

Does not require any comparable companies

Can be performed in Excel

Includes all future expectations about a business

Suitable for analyzing mergers and acquisition

Can be used to calculate the internal rate of return IRR of an investment

Scenarios can be built-in

Allows for sensitivity analysis

What are the Cons of DCF analysis?

Despite the advantages of the DCF analysis, it is also exposed to some disadvantages. The main drawback of DCF analysis is that it’s easily prone to errors, bad assumptions, and overconfidence in knowing what a company is actually “worth”.

The main Cons of a DCF model are:

Requires a large number of assumptions

Prone to errors

Prone to overcomplexity

Very sensitive to changes in assumptions

A high level of detail may result in overconfidence

Looks at company valuation in isolation

Doesn’t look at relative valuations of competitors

Terminal value is hard to estimate and represents a large portion of the total value

Challenging to estimate the Weighted Average Cost of Capital (WACC)