The basics of

Discounted Cash
Flow Valuation
The essence of intrinsic value
• In intrinsic valuation, you value an asset based upon its fundamentals
(or intrinsic characteristics).
• For cash flow generating assets, the intrinsic value will be a function
of the magnitude of the expected cash flows on the asset over its
lifetime and the uncertainty about receiving those cash flows.
• Discounted cash flow valuation is a tool for estimating intrinsic value,
where the expected value of an asset is written as the present value
of the expected cash flows on the asset, with either the cash flows or
the discount rate adjusted to reflect the risk.
Discounted Cash Flow Valuation (DCF)
• The value of a risky asset can be estimated by discounting the
expected cash flows on the asset over its life at a risk-adjusted
discount rate:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛
𝑉𝑜 = 1
+ 2
+ ⋯+
1+𝑟 1+𝑟 1+𝑟 𝑛
• However, listed firms can potentially live forever, so it is mechanically
not possible to estimate these cash flows indefinitely.
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛 𝑇𝑉
𝑉𝑜 = 1
+ 2
+⋯+ 𝑛
+
1+𝑟 1+𝑟 1+𝑟 1+𝑟 𝑛
DCF Choices: Equity Valuation versus Firm
Valuation
-

-
 dis rate - cost capital
cost equity

Firm valuation

(WACC)
 Equity valuation

Free CF to
equity
cost of equity
Firm value and equity value
• To get from firm value to equity value, which of the following would
you need to do?
a) Subtract out the value of long-term debt debt
that value value I
sure
I
b) Subtract out the value of all debt -make
0 ↓ is what you
me
in wice

⑧
c) Subtract the value of any debt that was included in the cost of capital
calculation liabilities
* subtract the value
of
all
A detour: What discount rates for which cash
flows?
• The collective cash flows the company generates is the free cash flow to the firm
(FCFF)
• For a cash flow generating company, any cash flows it generates first go to paying
lenders (hierarchy of claims).
• Lenders are owed interest and principal payment. Any cash flows left are what
equity holders are entitled to (although the company need not distribute them).
This is the Free Cash Flow to Equity (FCFF). *

• For FCFE, the appropriate discount rate to use is the cost of equity
• For FCFF, the appropriate discount rate to use is the cost of capital (WACC):
𝑬 iveq
->
𝑫 -> Mr debt

𝑾𝑨𝑪𝑪 = ∗ 𝑹𝑬 + ∗ 𝑹𝑫 (𝟏 − 𝑻) - tax

𝑬+𝑫 ↓
Ostes
𝑬+𝑫 wsw
I
debt

Where E is the market value of equity, D is the market value of debt, 𝑅𝐸 is the cost
of equity, 𝑅𝐷 is the cost of debt and T is the corporate tax rate.
Cash flows and discount rates
• Assume that you are analyzing a company with the following cashflows for the
next five years.
Year CF to equity Interest expense * (1-tax CF to firm
rate)
1 $50 $40 $90
2 $60 $40 $100
3 $68 $40 $108
4 $76.2 $40 $116.2
5 $83.49 $40 $123.49
Terminal value $1603 $2363

• Assume also that the cost of equity is 13.625% and the firm can borrow long term
at 10%. (The tax rate for the firm is 50%.)
• The current market value of equity is $1,073 and the value of debt outstanding is
$800.
Ve =E- + :
136 1 .

=$1073

WACC =

10 .
57 x 13 .
625) + 10 .
43 x 10 x 11-0 5).

we s
44
=

9 . =

0 57
.

a
- ...
Vi
t
=
wd= 1 We
~

1 . 09945 -

u' 43
-
0 .

2363
-

1
- 19945

= 1873
800
1873 -

Ve =

volved
fairly
equity
-

market
value o
Vet
CO mV
sell
covervalued
1500
sundervalued)
->
1073

900
- buy
1873
Equity vs. Firm valuation
• Method 1: Discount CF to Equity at Cost of Equity to get value of equity
• Cost of Equity = 13.625%
• Value of Equity = 50/1.13625 + 60/1.136252 + 68/ 1.136253 + 76.2/ 1.136254 +
(83.49+1603)/ 1.136255 = $1073

• Method 2: Discount CF to Firm at Cost of Capital to get value of firm

• Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1 - 0.5) = 5%
• Cost of Capital (WACC) = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
• Value of Firm = 90/1.0994 + 100/ 1.09942 + 108/ 1.09943 + 116.2/ 1.09944 +
(123.49+2363)/ 1.09945 = $1873
• Value of Equity = Value of Firm – Market Value of Debt
= $1873 – $800 = $1073
 debt
·

equity) risky
Linvestor's 10v]
-

First principle of valuation e

I
re)rd

re <WACC
wAcC
D re
=

if
0
=

• Discounting Consistency Principle: Never mix and match cash flows

and discount rates.
• Mismatching cash flows to discount rates is deadly.
• Discounting cash flows after debt cash flows (cash flows to equity) at the
weighted average cost of capital will lead to an upward bias in the estimate of
the value of equity.
• Discounting pre-debt cash flows (cash flows to the firm) at the cost of equity
will yield a downward bias in the estimate of the value of the firm.
WACC instead re
WACC
re instead VE
Ve
overstating
understating clower di)
dri
chigher
The Effects of Mismatching Cash Flows and
Discount Rates
• Error 1: Discounting CF to Equity at Cost of Capital to get equity value
2 3 4
• Value of Equity = 50/1.0994
5
+ 60/1.0994 + 68/ 1.0994 + 76.2/ 1.0994 +
(83.49+1603)/ 1.0994 = $1248
• Value of equity is overstated by $175 (= $1248 - $1073)
• Error 2: Discount CF to Firm at Cost of Equity to get firm value
2 3 4
• Value of Firm = 90/1.13625
5
+ 100/ 1.13625 + 108/ 1.13625 + 116.2/ 1.13625 +
(123.49+2363)/ 1.13625 = $1613
• Value of Equity = $1613 - $800 = $813
• Value of equity is understated by $260 (= $813 - $1073)
• Error 3: Discount CF to Firm at Cost of Equity and forget to subtract out
debt
• At that point I’ll just give up!
Discounted Cash
Flow Valuation:
The inputs
Discounted Cash Flow Valuation: The Steps
1. Estimate the discount rate or rates to use in the valuation
• Discount rate can be either a cost of equity (if doing equity valuation) or a cost of
capital (if valuing the firm)
• Discount rate can be in nominal terms or real terms, depending upon whether the
cash flows are nominal or real
• Discount rate can vary across time
2. Estimate the current earnings and cash flows on the asset, to either
equity investors (CF to Equity) or to all claimholders (CF to Firm)
3. Estimate the future earnings and cash flows on the firm being valued,
generally by estimating an expected growth rate in earnings. than
-lowe ! evnow

4. Estimate when the firm will reach “stable growth” and what usually 5-10y)
characteristics (risk & cash flow) it will have when it does.
5. Choose the right DCF model for this asset and value it.
Generic DCF valuation model
Same ingredients, different approaches…
Start easy: The Dividend Discount Model
Moving on up: The “potential dividends”
or FCFE model
To valuing the entire business: The FCFF
model