Using DCF models is in some sense an act of faith. We
believethateveryassethasanintrinsicvalueandwetryto
estimate that intrinsic value by looking at an asset’s
fundamentals.Whatisintrinsicvalue?Consideritthevalue
thatwouldbeattachedtoanassetbyanall-knowinganalyst
with access to all information available right now and a
perfectvaluationmodel.Nosuchanalystexists,ofcourse,but
we all aspire to be as close as we canbe to this perfect
analyst.Theproblemliesinthefactthatnoneofusevergets
to see what the trueintrinsic value of an asset isand we
therefore have no way of knowing whether our DCF
valuations are close to the mark.
Classifying Discounted Cash Flow Models
TherearethreedistinctwaysinwhichwecancategorizeDCF
models. In the first, we differentiate between valuing a
businessas a going concernas opposed to a collection of
assets.Inthesecond,wedrawadistinctionbetweenvaluing
theequityinabusinessandvaluingthebusinessitself.Inthe
third,welayouttwodifferentandequivalentwaysofdoing
DCF valuation in addition to the expected cash flow
approach—avaluebasedonexcessreturnsandtheadjusted
present value (APV).
Going Concern versus Asset Valuation
Thevalueofanassetin theDCFframeworkisthepresent
valueoftheexpectedcashflowsonthatasset.Extendingthis
propositiontovaluinga business,itcanbearguedthatthe
valueofabusinessisthesumofthevaluesoftheindividual
assetsownedbythebusiness.Whilethismaybetechnically
correct,thereisakeydifferencebetweenvaluingacollection