classroomsandcomeswiththebesttheoreticalcredentials.In
thissection,wewilllookatthefoundationsoftheapproach
andsomeofthepreliminarydetailsonhowweestimateits
inputs.
Basis for Approach
Webuymostassetsbecauseweexpectthemtogeneratecash
flowsforusinthefuture.InDCFvaluation,webeginwitha
simpleproposition.Thevalueofanassetisnotwhatsomeone
perceives itto be worth, but rather itis a functionof the
expectedcashflowsonthatasset.Putsimply,assetswithhigh
and predictable cash flowsshouldhavehigher valuesthan
assetswithlowandvolatilecashflows.InDCFvaluation,we
estimate thevalue of an asset as the presentvalue of the
expected cash flows on it.
where
E(CFt) = Expected cash flow in periodt
r= Discount rate reflecting riskiness of estimated cash flows
n= Life of asset
Thecashflowswillvaryfromassettoasset—dividendsfor
stocks,coupons(interest)andthefacevalueforbonds,and
after-taxcashflowsforabusiness.Thediscountratewillbea
function oftheriskiness ofthe estimatedcash flows,with
higher rates for riskier assets and lower rates for safer ones.