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Why Creating A Discounted Cash Flow Model Requires Expert-level Training?
The discounted cash flow model is a friend to all financial analysts. It is simple to use, yet extremely detailed and gives a peek into the future based on current values. However, the power of a discounted cash flow model (DCF) model can often backfire in amateur hands. Without adequate training, the conclusions of a DCF can be overinflated which might disrupt business decisions. Hence, it is crucial that you receive an expert-level training in DCF analysis before claiming that you can perform one and understand all the possible loopholes that can lead to wrong estimations.
DCF looks at the company in isolation
With DCF, you calculate the equity valuation of a company with the financial data of only that company.
The effects of macroeconomic factors on the company’s health are rarely reflected. Also, the influence of competition, changing customer taste or product quality is not captured in DCF which requires the financial analyst to make adequate rectification in the final intrinsic value. As evident, predicting the correction factor efficiently requires training.
DCF also needs making a host of assumptions
How do you predict the cash flow of a company 5 years from now to conclude as to what amount to invest today? Predicting that terminal value from where a discounted cash flow model starts require making multiple assumptions about the company in question. And these assumptions ultimately decide the accuracy of the forecasted intrinsic value. Only industry experts who have created or worked in various DCF know the correct ways of making these assumptions. Naturally, you should be learning from them to gain mastery to a similar level.
Estimating the WACC is a challenge
The Weighted Average Cost of Capital is a complicated formula that again requires a separate genre of statistical and business understanding to create a DCF model. With training, you can learn to eliminate unnecessary data with tools like Excel and work with only that information that is necessary. WACC is still manageable by internal financial analysts of a company who can retrieve and filter data from internal databases but accessing from a public platform can be a challenge. You need to coach along these lines to create an eye for taking out what is precisely required.
Lastly, DCF can cause financial biases
Experts often use comparable company analysis and precedent transactions in combination with DCF for equity valuation. DCF alone tends to return exaggerated results which might create a financial bias towards the lucrative number. As an analyst, you must be privy to this phenomenon. You must walk through training first to comprehend that overestimation does happen and DCF is not the absolute tool of measurement. Dependency on DCF is alright but you need to tackle the possible errors before they come and haunt your career.
So, do not underestimate the cons of the discounted cash flow model. Train from the right brand and sit through expert online coaching. At every step of your financial journey, you will encounter a DCF. And you need the sense to pinpoint the possible errors in the results that have been handed to you.
Rajiv G. is a Strategy and Corporate Finance Consultant with 15+ years of experience. Previously, he has worked with the Strategy and Corporate Finance practice at McKinsey & Company. He has advised clients globally in multiple industries on various Strategy and Finance engagements. Prior to this, he has worked as an Equity Research Analyst with CRISIL. He is a CFA and Chartered Accountant.
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