Encyclopedia of Financial Models II

Discounted Cash Flow Methods for Equity Valuation

GLEN A. LARSEN Jr., PhD, CFA

Professor of Finance, Indiana University Kelley School of Business–Indianapolis

Abstract: Most applied methods of valuing a firm’s equity are based on discounted cash flow and relative valuation models. Although stock and firm valuation is very strongly tilted toward the use of discounted cash flow methods, it is impossible to ignore the fact that many analysts use other methods to value equity and entire firms. The primary alternative valuation method is relative valuation. Both discounted cash flow and relative valuation methods require strong assumptions and expectations about the future. No one single valuation model or method is perfect. All valuation estimates are subject to model error and estimation error.

Sound investing requires that an investor does not pay more for an asset than its worth. There are those who argue that value is in the eyes of the beholder, which is simply not true when it comes to financial assets. Perceptions may be all that matter when the asset is an art object or antique automobile, but investors should not buy financial assets for aesthetic or emotional reasons; financial assets are acquired for the cash flows expected from them in future periods. Consequently, perceptions of value have to be backed up by reality, which implies that the price paid for any financial asset should reflect the cash flows that it is expected to generate.

Realize that at the end of the ...