Discounted Cash Flow Valuation

In discounted cash flow valuation, we estimate the value of any asset by discounting the expected cash flows on that asset at a rate that reflects their riskiness. In a sense, we measure the intrinsic value of an asset. The value of any asset is a function of the cash flows generated by that asset, the life of the asset, the expected growth in the cash flows and the riskiness associated with them. In other words, it is the present value of the expected cash flows on that asset.

Value of Asset = YE(Cash Flow.)

Û (1 + r)t where the asset has a life of N years and r is the discount rate that reflects both the riskiness of the cash flows and financing mix used to acquire the asset. If we view a firm as a portfolio of assets, this equation can be extended to value a firm, using cash flows to the firm over its life and a discount rate that reflects the collective risk of the firm's assets.

This process is complicated by the fact that while some of the assets of a firm have already been created, and thus are assets-in-place, a significant component of firm value reflects expectations about future investments. Thus, we not only need to measure the cash flows from current investments, but we also must estimate the expected value from future investments. In the sections that follow, we will introduce the discounted cash flow model in steps. We begin by discussing two different ways of approaching valuation -equity and firm valuation - and then move on to consider how best to estimate the inputs into valuation models, and then consider how to go from the value of a firm to the value of equity per share.

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