Why a Simple DCF Analysis isn’t Always the Best Option

The concept of incorporating growth opportunities in valuations.

Financial valuations have caught my attention for a while now. I find it fascinating how we can use a few numbers from a company’s financial statement to derive its inherent value. Like most, I value companies with a Discounted Cash Flow (DCF) analysis. This method works, sure, but there is one which I find more exciting, more thrilling, and I want to explain to you why.

Wait a second, what is a DCF?

A simple way to derive the attractiveness of an investment, where future cash flows come from past decisions. A DCF works by getting the present value of the future free cash flows a firm is expected to generate.

Sounds complicated? Let’s try again. The value of $100 in the future is worth less today because inflation causes money to lose value into the future. So, by discount, it simply means the rates we use to discount the future cash flows.

What’s wrong about a DCF?

Because future cash flows result from past decisions, these are fixed, but the future isn’t. Future decisions are influenced by two things: uncertainty and competition. If you make a decision only on the present situation, you will inevitably miss out on profitable opportunities.

There needs to be a valuation method that is open to uncertainty, open to the future, a valuation method that accounts for future decisions. Because if we are open to the future, we can explore and seize opportunities that lead to increased value. Makes sense, right?

The Expanded NPV

People, we need to shift our perspective from a static DFC valuation to a valuation that takes into account decisions not as isolated, but as a system of interactions. An investment cannot be valued solely from its value today, but from the future growth opportunities it can create. What we decide today influences our future, this is the key.

Now, to value our ABC company we need the Expanded NPV. This model brings together three things: a static DCF valuation, growth options, and game theory. The fantastic thing is that these are all carried out based on structured and quantitative analysis.

With this article, I hope to have somewhat shifted the static thinking behind DCF models and made a clear case on why the Expanded NPV is worth considering.