DCF models are based on the maxim that investors should maximize the present value of future cash flow. DCF models might help skilled investors to identify attractive securities. However, the use of DCF models does not ensure that portfolios have the risk and return characteristics which investors desire. Markowitz (1952) states:
“[…] The hypothesis (or maxim) that the investor does (or should) maximize discounted return must be rejected. If we ignore market imperfections the foregoing rule never implies that there is a diversified portfolio which is preferable to all non-diversified portfolios. Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.”1
According to Markowitz (1998) investors evaluate portfolios by looking at the expected returns and variances (or standard deviations) of the portfolios and seek to maximize their utility. A widely-used utility function states:
where E(rp) and Var(rp) are the expected return and future variance of a portfolio p, respectively. The term λ represents the risk aversion parameter of an investor.2 According to Markowitz (1952), the portfolio selection approach can be formulated as an optimization problem. If w is the vector of these asset weights, the investor-specific ...