The nature of the calculations used in discounted cash flow, or DCF, analysis make it more properly suited for use in evaluating certain types of industries or companies. DCF analysis is designed to give an evaluation of a company's current value, commonly designated as "net present value," by projecting its future free cash flows, or profits. It is a highly regarded valuation method, but it has some inherent problems that make its analysis more applicable in regard to certain industries or companies than to others.
Since DCF analysis projects future cash flows, it necessarily requires making estimates of operating costs, revenues and growth, estimates which can be significantly easier or more difficult to accurately predict due to the nature of a company's business. In short, larger and more firmly established companies with fairly steady growth histories to use as the basis for projections of future growth are better suited to evaluation by DCF analysis. It is much more difficult to forecast growth for small or beginning companies or any company or industry with greater exposure to seasonal or economic cycles. Another factor to consider is projected capital expenditures. Companies most likely to have fairly consistent levels of capital expenditures are easier to accurately analyze with DCF. For all these reasons, the companies most suited to DCF analysis are those in industries such as utilities, oil and gas or banking, industries where income, expenditures and growth tend to be relatively stable and steady over time.
The basic weakness of DCF analysis is the large amount of time it projects to cover, given the numerous variables involved. While operating costs and revenues may be fairly simple to accurately predict a year or two in advance, beyond that point making accurate projections becomes increasingly difficult. Also, any minor, early errors in forecasting costs and revenues become exponentially amplified in the projections for future years. Investors should be especially cautious of DCF analysis that attempts projections beyond a 10-year period.