Equity Valuation: Models from Leading Investment Banks

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Discounted Cash Flow Valuation

In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows. This approach gets the most play in academia and comes with the best theoretical credentials. In this chapter, we will look at the foundations of the approach and some of the preliminary details on how we estimate its inputs.

37.1 ESSENCE OF DISCOUNTED CASHFLOW VALUATION

We buy most assets because we expect them to generate cash flows for us in the future. In discounted cash flow valuation, we begin with a simple proposition. The value of an asset is not what someone perceives it to be worth but it is a function of the expected cash flows on that asset. Put simply, assets with high and predictable cash flows should have higher values than assets with low and volatile cash flows.

Using discounted cash flow models is in some sense an act of faith. We believe that every asset has an intrinsic value and we try to estimate that intrinsic value by looking at an asset's fundamentals. What is intrinsic value? Consider it the value that would be attached to an asset by an all-knowing analyst with access to all information available right now and a perfect valuation model. No such analyst exists, of course, but we all aspire to be as close as we can to this perfect analyst. The problem lies in the fact that none of us ever gets to see what the true intrinsic value ...