discountrates - Estimating Discount Rates DCF Valuation...

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Aswath Damodaran 1 Estimating Discount Rates DCF Valuation
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Aswath Damodaran 2 Estimating Inputs: Discount Rates Critical ingredient in 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 riskiness and the type of cashflow being 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
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Aswath Damodaran 3 Cost of Equity The cost of equity should be higher for riskier investments and lower for safer investments While 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 investor in the investment Most 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)
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Aswath Damodaran 4 The Cost of Equity: Competing Models Model Expected Return Inputs Needed CAPM E(R) = R f + β (R m - R f ) Riskfree Rate Beta relative to market portfolio Market Risk Premium APM E(R) = R f + Σ j=1 β j (R j - R f ) Riskfree Rate; # of Factors; Betas relative to each factor Factor risk premiums Multi E(R) = R f + Σ j=1,,N β j (R j - R f ) Riskfree Rate; Macro factors factor Betas relative to macro factors Macro economic risk premiums Proxy E(R) = a + Σ j=1..N b j Y j Proxies Regression coefficients
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Aswath Damodaran 5 The CAPM: Cost of Equity Consider the standard approach to estimating cost of equity: Cost of Equity = R f + Equity Beta * (E(R m ) - R f ) where, R f = Riskfree rate E(R m ) = Expected Return on the Market Index (Diversified Portfolio) In practice, Short term government security rates are used as risk free rates Historical risk premiums are used for the risk premium Betas are estimated by regressing stock returns against market returns
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Aswath Damodaran 6 Short term Governments are not riskfree in valuation…. On a riskfree asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return.
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