Why might DCF not be applicable to certain business models?

The discounted cash flow (DCF) method relies heavily on the predictability and reliability of a company's future cash flows to determine its value. When considering various business models, there are several reasons why DCF may not be suitable.

First, if a business lacks reliable cash flow, it becomes difficult to project future cash flows accurately, which undermines the foundational premise of DCF analysis. Reliable cash flows are essential for an effective DCF valuation because they allow for reasonable estimations and confidence in the forecast.

Second, companies with negative free cash flow are inherently challenging for DCF analysis. Negative free cash flow indicates that a company is spending more on operating and capital expenses than it is generating from its operations. This could signal that the company is in a growth phase or facing challenges, making it hard to assign a positive value through DCF methods since future cash inflows are uncertain.

Lastly, cyclical businesses experience regular fluctuations in performance based on economic cycles. During downturns, these businesses may provide inconsistent or unpredictable cash flows, complicating the forecasting process essential for DCF analysis. Since DCF is based on expected future cash flows, cyclical nature can lead to inflated or deflated valuations based on which phase of the cycle is being evaluated.

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