Problems with DCF

Was reading a part in Bruce Wasserstein’s Big Deal on DCF, he highlighted 3 situations that are difficult to analyse using DCF:

  1.  A company with ‘hockey stick’ projections – a firm with mediocre historical performance that is projected to undergo a dramatic turnaround. The timing, scope, cash impact, and long-term stability of the turnaround plays havoc with the DCF technique.
  2. A company in a cyclical industry. The danger of the DCF method is that the impact of a part of the cycle closest to the present is exaggerated by the discounting technique: near-term cash flows are given greater weight than cash flows in outer years. Hence a DCF would value more highly a cyclical company in the upswing part of its cycle than a company in the downswing part. But regardless of where a company is in its business cycle, it should maintain the same intrinsic value.
  3. High-growth or start-up companies. These companies often have negative cash flow in the early years. Projecting the nature of the company’s subsequet performance is dicey. In addition, the cost of capital generally must be calculated based on industry comparables, of which there might not be any.


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