What is one limitation of DCF analysis?

One significant limitation of DCF (Discounted Cash Flow) analysis is that it relies heavily on future projections. This reliance on forecasted cash flows is critical because the entire valuation is predicated on accurate estimations of how much cash a company will generate in the future and how much of that cash will be accessible to investors.

If these projections are overly optimistic or lack a solid foundation based on market dynamics, operational realities, or company-specific circumstances, it can lead to a distorted valuation. Moreover, predicting future cash flows is inherently uncertain, as it requires assumptions about revenue growth, expenses, capital expenditure, and market conditions that can change abruptly. This makes the DCF approach sensitive to small changes in these underlying assumptions, which can result in large variances in the estimated value of the company being analyzed.

The limitations associated with data requirements, external factors, or applicability to certain types of companies are relevant but secondary to the fundamental issue of dependence on future projections, as even well-established companies can face forecasting challenges and market uncertainties.