DCF ValuationCopy Anchor Link

DCF ValuationCopy Anchor Link

Discounted cash flow (DCF) valuation is the standard machinery for estimating intrinsic-value. Its premise, as Damodaran states it, is that "The value of an asset is the present value of the expected cash flows on that asset, over its expected life." It is the method that turns the three drivers — cash flow, growth, and risk — into a number.

The method branches on which claimholder's cash flows are being discounted. "The value of equity is obtained by discounting expected cashflows to equity" at the cost of equity, while "The value of the firm is obtained by discounting expected cashflows to the firm" at the weighted average cost of capital. The two paths must not be mixed: equity cash flows (residual, after debt) against the cost of equity; firm cash flows (before debt) against the WACC.

Free cash flow is the operating surplus, not accounting earnings. To the firm it starts with after-tax operating income, less reinvestment; to equity it is "residual cash flows for equity investors, i.e., cash flows left over after every conceivable need has been met." The subtraction matters because growth consumes capital: "Net capital expenditures represent the difference between capital expenditures and depreciation."

Growth and reinvestment are locked together in a DCF. Expected cash flow equals expected earnings minus the reinvestment needed to produce future growth, so an assumption about one cannot be made independently of the other. The terminal value — the bulk of most valuations — then rests on a mature-company assumption, with a growth rate below the economy's nominal rate.

Damodaran's distinctive contribution is insisting the model must be fed by a story. "Every valuation starts with a narrative, a story that you see unfolding for your company in the future." Each driver — market size, share, margin, reinvestment — is a place where that narrative converts to a number. A DCF with no narrative is vulnerable to "The illusion of precision", and a narrative with no numbers veers into fantasy.

Because the inputs are uncertain, the DCF is meant to be stress-tested. Damodaran's toolkit runs from sensitivity analysis, through scenario analysis, to full simulation — "Using probability distributions for key inputs, rather than expected values, and computing value as a distribution as well". The output is a range, not a point — which is what lets a margin of safety be set against it. See margin-of-safety, equity-risk-premium for the discount rate's key input, and accounting-quality for why the cash-flow line is itself an adjustment of reported figures.

See alsoCopy Anchor Link

• reverse-dcf
• fcfe-vs-fcff
• damodaran-vs-buffett-valuation

SourcesCopy Anchor Link

• damodaran/markdown/OmahaValueInvesting.md
• damodaran/markdown/valuation.md
• damodaran/markdown/cashflow.md
• damodaran/markdown/valueversuspriceNew.md
• damodaran/markdown/narrative&numbers.md
• damodaran/markdown/probabilistic.md