What is one limitation of the Discounted Cash Flow method?

The Discounted Cash Flow (DCF) method's reliance on assumptions and estimates is indeed a significant limitation. When conducting a DCF analysis, analysts must make a variety of assumptions regarding future cash flows, growth rates, discount rates, and the overall economic environment. These assumptions are inherently uncertain, and slight changes in them can lead to substantial differences in the calculated value of the asset or company being analyzed.

For example, if an analyst overestimates future revenue growth or underestimates the cost of capital, the resulting DCF valuation may look overly optimistic. This model's sensitivity to input assumptions means that it can introduce bias, leading to potentially flawed investment decisions if not approached with caution.

This limitation contrasts starkly with other methods, such as comparative analysis or asset-based valuations, which may rely more on historical data or market transactions and involve less uncertainty about future estimates. While historical data plays a role in setting assumptions, the significant factor that sets DCF apart is how these expectations must be articulated and justified, thus creating room for personal bias in the predictions made.