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Advantages
The alternatives to DCF are relative valuation measures, which use multiples to compare stocks within a sector. While relative valuation metrics such as P/E ratios are fairly simple to calculate, they aren't very useful if an entire sector or market is over or undervalued. A carefully designed DCF, by contrast, should help investors steer clear of companies that look inexpensive against expensive peers.
Unlike standard valuation tools such as the P/E ratio, DCF relies on free cash flows. For the most part, free cash flow is a trustworthy measure that cuts through much of the arbitrariness and "guesstimates" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense or turned into an asset on the balance sheet, free cash flow tracks the money left over for investors.
Best of all, you can also apply the DCF model as a sanity check. Instead of trying to come up with a fair value stock price, you can plug the company's current stock price into the DCF model and, working backwards, calculate how quickly the company would have to grow its cash flows to achieve the stock price. DCF analysis can help investors identify where the company's value is coming from and whether or not its current share price is justified.
Disadvantages
Although DCF analysis certainly has its merits, it also has its share of shortcomings. For starters, the DCF model is only as good as its input assumptions. Depending on what you believe about how a company will operate and how the market will unfold, DCF valuations can fluctuate wildly. If your inputs - free cash flow forecasts, discount rates and perpetuity growth rates - are wide of the mark, the fair value generated for the company won't be accurate, and it won't be useful when assessing stock prices. Following the "garbage in, garbage out" principle, if the inputs into the model are "garbage", then the output will be similar.
DCF works best when there is a high degree of confidence about future cash flows. But things can get tricky when a company's operations lack what analysts call "visibility" - that is, when it's difficult to predict sales and cost trends with much certainty. While forecasting cash flows a few years into the future is hard enough, pushing results into eternity (which is a necessary input) is nearly impossible. The investor's ability to make good forward-looking projections is critical - and that's why DCF is susceptible to error.
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