Six DCF Common Mistakes

The Discounted Cash Flow (DCF) model is one of the most common models for valuing companies. The model requires various parameters, including estimating the growth rate, understanding the basis for sales, estimating the considerable expenses, estimating the price of capital, and more.

There is a saying that says - paper suffers for everything. This is true. But when building a valuation using the DCF model, one should see that the results make sense. We have compiled for you some mistakes that should be avoided.

Because of its complexity, we found it appropriate to name a few common mistakes that can lead to an incorrect company valuation.

For convenience - we will divide the mistakes into two - errors that will lead to a high value and mistakes that will lead to a value lower than the actual value of the company.

1. Mistakes in Growth Rates - Considering Growth Rates Too High Relative to Historical Growth Rates

The first mistake is considering growth rates too high relative to historical growth rates. The first thing to look at is the company's historical growth rates. Growth rates tend to decrease over time. Unless there are exceptional circumstances - for example - launching a new product to the market or granting a patent to the company. Thus, when building a DCF model, one has to look at the company's historical growth rate. If the growth rate in recent years was 5%, the model could not assume 10% growth.

2. Mistakes in Growth Rates - a Growth Rate That Increases Over Time

Due to market competition, the company's growth rates tend to fade over time. Therefore - it can not be that the company's growth rate will increase over the entire forecast period - 5% in the first year, 7% in the third year, and 10% in the fifth year. Growth rates should decline until they stabilize at long-term growth rates.

3. Lack of Customers to Support Growth Rates

One of the common mistakes is the unreasonableness of the model, which stems from the lack of customers who will support the company's growth. If, for example, the company sells products to children in a specific geographical area. Check if there are enough children in the same area? If sales of $ 1 million in a given year mean that products have to be sold to 100,000 children, it must be examined whether there are 100,000 children in the geographical area at all?

4. Mistakes in Profit Margin Rates

Similar to growth rates - the company operates in a competitive environment. The profit margin is expected to reduce over time due to the competition. Thus - it is impossible that the margin rate in the fifth year will be the highest relative to all other years.

5. Lack of Financial Resources to Realize Growth

The DCF should express a theoretical model and the company's future development. It must therefore be examined whether the company has sufficient financial resources to grow. If, for example - $ 1 million is needed to realize the company's growth, it should be examined - does the company have the financial resources to finance it?

6. WACC Errors

error in the weighted average cost of capital (WACC). The weighted average capital price describes the discount rate. The weighted average cost of capital weighs two capital prices - the price of foreign capital and the price of equity. The unskilled appraiser often uses a specific discount rate, such as 10%, without ensuring a basis for that discount rate. When a particular cost of capital is mentioned, it must be built according to the finance theory and applied correctly.

Conclusion

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