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  • Writer's pictureOne Hat Research LLC

What Do You Want the Value to Be?

The DCF Valuation Methodology is Untestable (and Therefore Unreliable)

The discounted cash flow (DCF) valuation methodology is ubiquitous in  finance, but as a single equation in a potentially-infinite set of unobservable unknowns, it is unfalsifiable and therefore untestable. While bonds can be viewed as examples of DCF pricing, this depends on their prices often being observable and their ``expected" cash flows typically being bounded above by their promised cash flows.

For capital projects, businesses, and common stocks, there is simply no way to determine whether a DCF valuation is a good representation of the causal mechanisms behind market values. The untestable nature of DCF may generate bad consequences for business decision-making, first by causing the rejection of otherwise good projects through heavy discounting of long-term cash flows, and second by making it more likely that only the most excessively optimistic cash flow forecasts make it through the capital budgeting process.

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DCF Untestable
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