Why is backtesting important in DCF valuation?

Backtesting is a critical process in DCF (Discounted Cash Flow) valuation as it allows practitioners to validate the accuracy of their cash flow predictions by comparing them with actual performance over time. When analysts make projections about future cash flows, they inherently carry a degree of uncertainty. By using backtesting, analysts can review past forecasts against realized outcomes to evaluate how well their models performed prior to making current assessments.

This process provides objective evidence of the reliability and credibility of the forecasting model. If past predictions were accurate, it instills confidence in the current projections, which in turn aids investors and stakeholders in making informed decisions. Consequently, backtesting is a key component in refining the forecasting process, thereby enhancing the robustness of DCF analysis and its effectiveness for investment decisions.