“There is a great deal of mythology around DCF valuation, some of it promoted by model-users and some by model-haters,” writes Dr. Aswath Damodaran (New York University Stern School of Business). He has set out his 10 common myths of discounted cash flow analysis and will examine each one in his blog over the rest of the year. Here they are:
- Myth 1: If you have a D (discount rate) and a CF (cash flow), you have a DCF. As a DCF observer, I see a lot of pseudo-DCF, DCFs in drag, and other fake DCFs being pushed as discounted cash flow valuations.
- Myth 2: A DCF is an exercise in modeling and number crunching. There is no room for creativity or qualitative factors.
- Myth 3: You cannot do a DCF when there is too much uncertainty, thus making it useless as a tool in valuing startups, companies in emerging markets, or during macroeconomic crises.
- Myth 4: The most critical input in a DCF is the discount rate, and, if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
- Myth 5: If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF, since the value rests almost entirely on what you assume in that terminal value.
- Myth 6: A DCF requires too many assumptions and can be manipulated to yield any value you want.
- Myth 7: A DCF cannot value brand name or other intangibles.
- Myth 8: A DCF yields a conservative estimate of value. It is better to underestimate value than overestimate it.
- Myth 9: If your DCF value changes significantly over time, there is either something wrong with your valuation (since intrinsic value should not change over time) or it is pointless (since you cannot make money on a shifting value).
- Myth 10: A DCF is an academic exercise, making it useless for investors, managers, or others who inhabit the real world.
‘Twisted’ DCF: In his first post in the series, Damodaran challenges what he says is a widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash) F(lows). He examines what he calls a “twisted” DCF, “where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.”
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