Aswath
Damodaran
1
Discounted Cashflow Valuation:
Equity and Firm Models
Aswath Damodaran

Aswath
Damodaran
2
Summarizing the Inputs
In summary, at this stage in the process, we should have an estimate of the
•
the current cash flows on the investment, either to equity investors (dividends or
free cash flows to equity) or to the firm (cash flow to the firm)
•
the current cost of equity and/or capital on the investment
•
the expected growth rate in earnings, based upon historical growth, analysts
forecasts and/or fundamentals
The next step in the process is deciding
•
which cash flow to discount, which should indicate
•
which discount rate needs to be estimated and
•
what pattern we will assume growth to follow

Aswath
Damodaran
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Which cash flow should I discount?
Use Equity Valuation
(a) for firms which have stable leverage
, whether high or not, and
(b) if equity (stock) is being valued
Use Firm Valuation
(a) for firms which have leverage which is too high or too low
, and expect to change
the leverage over time, because debt payments and issues do not have to be
factored in the cash flows and the discount rate (cost of capital) does not change
dramatically over time.
(b) for firms for which you have
partial information on leverage
(eg: interest expenses
are missing..)
(c) in all other cases, where you are more interested in valuing the firm
than the equity.
(Value Consulting?)

Aswath
Damodaran
4
Given cash flows to equity, should I discount dividends or
FCFE?
Use the Dividend Discount Model
•
(a) For firms which pay dividends (and repurchase stock) which are close to the
Free Cash Flow to Equity (over a extended period)
•
(b)For firms where FCFE are difficult to estimate (Example: Banks and Financial
Service companies)
Use the FCFE Model
•
(a) For
firms which pay dividends which are significantly higher or lower than the
Free Cash Flow to Equity. (What is significant? ... As a rule of thumb, if dividends
are less than 80% of FCFE or dividends are greater than 110% of
FCFE over a 5-
year period, use the FCFE model)
•
(b) For firms where dividends are not available (Example: Private Companies,
IPOs)

Aswath
Damodaran
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What discount rate should I use?
Cost of Equity versus Cost of Capital
•
If discounting cash flows to equity -> Cost of Equity
•
If discounting cash flows to the firm
-> Cost of Capital
What currency should the discount rate (risk free rate) be in?
•
Match the currency in which you estimate the risk free rate to the currency of your
cash flows
Should I use real or nominal cash flows?
•
If discounting real cash flows
-> real cost of capital
•
If nominal cash flows
-> nominal cost of capital
•
If inflation is low (<10%), stick with nominal cash flows since taxes are based upon
nominal income
•
If inflation is high (>10%) switch to real cash flows

Aswath
Damodaran
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Which Growth Pattern Should I use?

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- Spring '11
- tnaga
- Cost Of Capital, Net Present Value, Dividend yield