What are the pros and cons of discounted cash flow analysis in IB deal valuation?

DCF analysis is a good method to arrive at the intrinsic valuation of the company based on estimated future cash flows. At the same time, therein lies the biggest drawback given it rleies on "estimated cash flows". Estimates are based on assumptions on various parameters which itself could be questionable ! Were the assumptions too optimistic or too pessimistic. A better approach could be use multiple other valuation methods to arrive at a valuation range and then use DCF valuation as a reality check to evaluate whether it throws up valuation numbers in broadly the same range !

The DCF analysis is relied on more heavily in the absence of relevant public and acquisition comps. When a company is too bespoke / niche to identify "pure play" comps, the DCF allows you to articulate the valuation story unique to that company. Generally speaking, you are utilizing the public comps, acquisition comps and the DCF to "triangulate" on value - shoutout to Phil Jackson and Tex Winter. Students interviewing for Investment Banking roles - feel free to utilize this answer (maybe absent the basketball reference). Connect with / message me if you have additional questions. Happy to be helpful!

DCF analysis helps find the real value of something by calculating its future cash flow worth today. It's great because it considers various factors like growth, expenses, and discount rates, letting you test different scenarios to see how they affect the value.

While a valid method, buyers on SMEs overwhelmingly focus on historical cash flows and T12 earnings. DCF is nice to have, but is unlikely to carry much weight in many negotiations.

Cons of DCF Analysis: Future Uncertainty: Predicting far ahead is tough. Relies on Assumptions: Based on many guesses about growth. Sensitivity to Inputs: Small changes affect results. No Guarantee: Results depend on future accuracy.

DCF is often complex to model and often has multiple variables that may be unnecessary to determining value. In a DCF often the majority of the value is in the terminal value and not in the usual 10 year cash flow period, so assumptions about the terminal growth rate etc. often have the greatest impact on value. Alternate valuation methods are equally valid and less complex.

Top alternatives: Comparable Companies Analysis (CCA): Looks at similar companies' market values. Comparable Transactions Analysis (CTA): Considers prices from similar deals. Asset-Based Valuation (ABV): Calculates value based on assets owned.

Purpose: Decide why you need the valuation (sale, investment, etc.). Nature: Consider the type of asset or company you're valuing. Comparable: Look at similar valuations in the market. Income & Assets: Use methods based on earnings or assets, depending on what fits. Expert Advice: Get help from professionals if needed.

Practice: Do more DCF analyses regularly. Understand Inputs: Grasp the key elements - cash flow, discount rate, terminal value. Learn Sensitivity: See how changes in inputs affect outcomes. Industry Study: Understand industry specifics for better predictions. Get Feedback: Review with experts for improvement.