Damodaran on Valuation

4.5. ESTIMATION APPROACHES

There are three approaches that are used to estimate cash flows in valuation. The simplest and most widely used is the expected value approach, where analysts estimate an expected cash flow for each time period, allowing implicitly or explicitly for good and bad scenarios. The second is a variant, where cash flows are estimated under different scenarios, ranging from best case to worst case, with values estimated under each scenario. The last and most information-intensive is to estimate probability distributions for each input and to run simulations, where outcomes are drawn from each distribution and values estimated with each simulation.

4.5.1. Expected Value

In most valuations, analysts estimate expected cash flows in each time period from investing in a business or an asset. The expected cash flow represents the single best estimate of the cash flow in a period and, computed correctly, should encapsulate the likelihood of both good and bad outcomes. This should therefore require a consideration of the probabilities of each scenario occurring and the cash flow under each scenario. In practice, however, such detailed analysis is almost never done, with analysts settling for an expected value for each variable (revenue growth, operating margin, tax rate, etc.) that determines cash flows. In the process, we do expose ourselves to the following errors:

• Some analysts use "best case" or "conservative" estimates instead of true expected values for the ...