Aswath1DamodaranEstimating Discount RatesDCF ValuationAswath1Damodaran

Aswath2DamodaranEstimating Inputs: Discount RatesCritical ingredientin discounted cashflow valuation. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation.At an intuitive level, the discount rate used should be consistent with both the riskinessand the type of cashßowbeing 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

Aswath3DamodaranCost of EquityThe cost of equity should be higher for riskier investmentsand lower for safer investmentsWhile risk is usually defined in terms of the variance of actual returns around an expected return, risk and return models in finance assume that the risk that should be rewarded (and thus built into the discount rate) in valuation should be the risk perceived by the marginal investorin the investmentMost risk and return models in finance also assume that the marginal investor is well diversified,and that the only risk that he or she perceives in an investment is risk that cannot be diversified away (I.e, market or non-diversifiable risk)Aswath3Damodaran

Aswath4DamodaranThe Cost of Equity: Competing ModelsModelExpected ReturnInputs NeededCAPME(R) = Rf+ (Rm- Rf) Riskfree RateBeta relative to market portfolio Market Risk PremiumAPME(R) = Rf+ j=1 j (Rj- Rf)Riskfree Rate; # of Factors;Betas relative to each factor Factor risk premiumsMultiE(R) = Rf+ j=1,,N j (Rj- Rf) Riskfree Rate; Macro factorsfactorBetas relative to macro factorsMacro economic risk premiums ProxyE(R) = a + j=1..NbjY jProxiesRegression coefficients

Aswath5DamodaranThe CAPM: Cost of EquityConsider the standard approach to estimating cost of equity: Cost of Equity = Rf+ Equity Beta * (E(Rm) - Rf)where,Rf= Riskfree rateE(Rm) = Expected Return on the Market Index (Diversified Portfolio)In practice,Short term government security ratesare used as risk free ratesHistorical risk premiumsare used for the risk premiumBetas are estimated by regressing stock returns against market returns Aswath5Damodaran

Aswath6DamodaranShort term Governments are not riskfree in valuation....On a riskfree asset, the actual return is equal to the expected return.

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