Some of the key problems with DCF are that:
- The cash flow projection for each year in the model may be uncertain, with this uncertainty increasing with each additional year. Discounted cash flow models often use 5 or even 10 years of estimates. Small errors or incorrect assumptions in the early years can have a huge effect on the later years.
- Capital expenditure assumptions can be inaccurate. Again, the potential for inaccuracies grows with each year in the model.
- The discount rate and growth rate assumptions may not be correct. Using the weighted average cost of capital (WACC) is common, but this may not work well for real-world (rather than theoretical) investments.
Discounted cash flow is a valuable formula investors can use to evaluate a potential investment based on the estimated future returns. It’s not the only way to assess potential investment opportunities, but when used with other formulas, it can help predict an investment’s profitability potential.