Discounted Cash Flow Valuation::The Inputs


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Estimating Inputs: Discount Rates

Critical ingredient in discounted cashflow valuation. Errors in
estimating the discount rate or mismatching cashflows and discount
rates can lead to serious errors in valuation.
l At an intuitive level, the discount rate used should be consistent with
both the riskiness and the type of cashflow being discounted.
– Equity versus Firm: If the cash flows being discounted are cash flows to
equity, the appropriate discount rate is a cost of equity. If the cash flows
are cash flows to the firm, the appropriate discount rate is the cost of
capital.
– Currency: The currency in which the cash flows are estimated should also
be the currency in which the discount rate is estimated.
– Nominal versus Real: If the cash flows being discounted are nominal cash
flows (i.e., reflect expected inflation), the discount rate should be nominal


Cost of Equity

The cost of equity is the rate of return that investors require to make an
equity investment in a firm. There are two approaches to estimating
the cost of equity;
– a dividend-growth model.
– a risk and return model
l The dividend growth model (which specifies the cost of equity to be
the sum of the dividend yield and the expected growth in earnings) is
based upon the premise that the current price is equal to the value. It
cannot be used in valuation, if the objective is to find out if an asset is
correctly valued.
l A risk and return model, on the other hand, tries to answer two
questions:
– How do you measure risk?
– How do you translate this risk measure into a risk premium?


Limitations of the CAPM

1. The model makes unrealistic assumptions
2. The parameters of the model cannot be estimated precisely
– - Definition of a market index
– - Firm may have changed during the 'estimation' period'
3. The model does not work well
– - If the model is right, there should be
* a linear relationship between returns and betas
* the only variable that should explain returns is betas
– - The reality is that
* the relationship between betas and returns is weak
* Other variables (size, price/book value) seem to explain differences in
returns better.


The Riskfree Rate

On a riskfree asset, the actual return is equal to the expected return.
Therefore, there is no variance around the expected return.
For an investment to be riskfree, i.e., to have an actual return be equal
to the expected return, two conditions have to be met –
– There has to be no default risk, which generally implies that the security
has to be issued by the government. Note, however, that not all
governments can be viewed as default free.
– There can be no uncertainty about reinvestment rates, which implies that it
is a zero coupon security with the same maturity as the cash flow being
analyzed.