Chapter 5 - Discounted Cash Flow Models

Abstract

The capital asset pricing model and similar risk premium models focus on understanding the risk–return trade-off in capital markets. The discounted cash flow (DCF) model attempts instead to estimate the cost of capital by analyzing the security's expected future cash flows relative to its current price. The DCF model assumes that the current price equals the sum of those expected future cash flows discounted at a constant discount rate, and it solves for the discount rate that equates that sum with the price. We address implementation issues, including difficulty in determining the security's expected future cash flows, as well as issues inherent in the fundamental theoretical assumptions underlying the DCF. In particular, we caution against an absolute reliance on the assumption that the price of a stock is given by the present value formula. Valuing options requires techniques other than the DCF formula, such as the well-known Black–Scholes model.