The Discounted Cash Flow (DCF) Method Applied to Valuation: Too Many Uncomfortable Truths

Abstract

The subprime crisis was an important wake up call for the financial discipline and the academic community. Several fundamental tenets of the field were called into question as the empirical evidence showed that they were less solid than previously believed. Currently, the list of issues under examination is long and challenging. It goes from basic ideas (are markets stable? are investors rational and homogeneous?) to more specialized topics (does the Value-at-Risk metric work? are credit ratings reliable?) The conventional Discounted Cash Flow (DCF) method -- since it did not play any role in the crisis -- has gone so far unexamined. Yet, with or without subprime crisis, it remains one of the weakest and most difficult to defend elements of the financial canon.

Keywords: discounted cash flow method, valuation, DCF

JEL Classification: C0, G0