Issues in using DCF for equity valuation.

Equity valuation is a critical process for investors and analysts, but it often involves assumptions and estimates that can impact accuracy. While all valuation models have their limitations, the Discounted Cash Flow (DCF) approach has unique challenges that make it particularly problematic. This blog explores the reasons why DCF may not be the most reliable method for equity valuation.

Key Issues with DCF in Equity Valuation

Unobservable Assumptions Cannot Be Validated
Most valuation models rely on assumptions like sales growth rates and profit margins, which can be validated once actual financial results are available. However, DCF introduces additional assumptions that are inherently unobservable, including:
- Cost of Equity
- Terminal Growth Rate
- Weights for Capital Components (WACC)
These assumptions cannot be validated even after years of analysis. For instance, if a terminal growth rate of 5% is used, there is no way to confirm whether the industry will grow at that rate indefinitely. Similarly, determining whether the cost of equity or market risk premium used was accurate requires near-impossible real-time investor surveys.
Difficulty in identifying high growth period
DCF models often employ a multi-stage approach:
- Stage 1: Forecasting the high-growth period
- Stage 2: Calculating the exit or perpetual value
While businesses eventually mature, pinpointing the duration of their high-growth phase is extremely challenging. For example, many technology companies continue to experience double-digit growth decades after their inception. DCF forces analysts to predict when this growth will taper off—a task fraught with uncertainty.
Relies a lot on unreliable long term forecasts
Unlike relative valuation methods, which focus on financial metrics for the next 12–24 months, DCF requires year-by-year forecasts over extended periods. The farther into the future these forecasts go, the less reliable they become. For instance:
- A company may have insights into sales trends for an upcoming festive season.
- However, predicting sales five years ahead is far less accurate.
This reliance on long-term assumptions further diminishes the reliability of DCF models.

Should DCF Be Completely Avoided?

While DCF has significant drawbacks, it can still serve as a useful tool in certain scenarios. For example:

It can be used to back-calculate business performance requirements to justify current valuations.
This approach provides a sanity check on whether a valuation is reasonable.

More insights on this topic will be shared in future blogs.