Why Discounted Cash Flow Valuations Will Make You Question Everything?

In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. The cash flow could be either the dividend which is actually paid out to shareholders or free cash flow which is accrued to the firm or to the shareholders. The basic principle behind the DCF models is that every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. The information required in order to find out the intrinsic value of any asset using DCF is as following :-

• to estimate the life of the asset
• to estimate the cash flows during the life of the asset
• to estimate the discount rate to apply to these cash flows to get present value

In case of a stock, the assumption of going concern entails that we use perpetuity as our estimated life of a company (and hence stock) unless conditions require assumptions otherwise. The estimate of cash flow could be divided as, Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE) depending upon the exact method of DCF valuation we choose. The discount rate used to deduce the present value should reflect the uncertainty (risk) of the cash flows and opportunity cost of capital. (Please refer to earlier section on Opportunity cost)

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