The Valuation Handbook: Valuation Techniques from Today's Top Practitioners

CHAPTER 5

Developing an Automated Discounted Cash Flow Model

 

Robert J. Atra

Chair of the Finance Department, Lewis University

Rawley Thomas

President, LifeCycle Returns, Inc.

 

 

intrinsic value is the investment concept on which our views ofsecurity analysis are founded. Without some defined standards ofvalue for judging whether securities are over or underpriced inthe marketplace, the analyst is a potential victim of the tides ofpessimism and euphoria which sweep the security markets.

—Cottle, Murray, and Block (Graham and Dodd’s Security Analysis, 5th Edition, 1988)

 

 

Discounted cash flow (DCF) forms the core of finance. While its basic structure has existed for many years, DCF valuation now takes many forms, from the simplistic, such as the Gordon model, to the extraordinarily sophisticated, such as proprietary free cash flow models. Though professionals may employ other methods of valuation, such as relative valuation and the contingent claims approach, DCF forms the basis for all other valuation (Damodaran 2002).

Underscoring the importance of DCF valuation is the fact that it provides a linchpin to link various fields of finance. Security analysts should value stocks in much the same manner as corporate managers value projects. In the case of a project, managers estimate cash flows and discount them back to the present. They then net the present value of those cash flows against the cost of the project and decide whether to accept or reject the project. Since, conceptually, ...