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Series 79 practice questionmediumDCF Analysis

Which of the following is a key limitation of the DCF valuation methodology?

  1. AIt is highly sensitive to assumptions about long-term growth rates and discount rates✓ Correct answer
  2. BIt relies on market-based multiples that may be distorted by market sentiment
  3. CIt cannot incorporate tax benefits of debt financing
  4. DIt requires publicly traded comparable companies to be effective
Explanation

Why A — It is highly sensitive to assumptions about long-term growth rates and discount rates

The DCF methodology is inherently sensitive to key assumptions, particularly the terminal growth rate and the discount rate (WACC). Small changes in these inputs can significantly alter the implied valuation, which is why investment bankers typically present DCF results as a range using sensitivity tables. Unlike comparable company analysis, a DCF does not rely on market multiples or public comparables, but its reliance on projected cash flows introduces forecast risk.

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