Estimating Inputs in Discounted Cash Flow Valuation

The inputs to a discounted cash flow (DCF) valuation are the free cash flows (FCFs) and the discount rate. The FCFs are the cash flows that are available to the company’s investors after it has paid for its operating expenses and capital expenditures. The discount rate is a measure of the riskiness of the investment.

The FCFs are the most important input to a DCF valuation. They are difficult to estimate, but there are a few methods that can be used. One method is to use the company’s historical FCFs as a starting point. However, it is important to adjust the historical FCFs for any changes in the company’s operations or the economic environment.

Another method for estimating FCFs is to use the company’s financial statements. The financial statements can be used to estimate the company’s revenue, expenses, and capital expenditures. Once these items have been estimated, the FCFs can be calculated.

The discount rate is also an important input to a DCF valuation. It is the rate that investors require to forgo current consumption in order to invest in the business. The discount rate can be estimated using a variety of methods, such as the capital asset pricing model (CAPM).

The CAPM is a model that uses the risk-free rate and the beta of the company to estimate the discount rate. The risk-free rate is the rate of return on a risk-free investment, such as a U.S. Treasury bond. The beta of the company is a measure of its volatility relative to the market.

Once the FCFs and the discount rate have been estimated, they can be used to calculate the present value of the business. The present value is the value of the business today, taking into account the future cash flows and the riskiness of the investment.

Here are some multiple choice questions (MCQs) on estimating inputs in discounted cash flow valuation:

  1. Which of the following is not an input to a discounted cash flow valuation?
    • Free cash flows (FCFs)
    • Discount rate
    • Terminal value
    • Market capitalization
    • Answer: Market capitalization
  2. Which of the following methods can be used to estimate FCFs?
    • Use the company’s historical FCFs as a starting point.
    • Use the company’s financial statements.
    • Use the capital asset pricing model (CAPM).
    • All of the above
    • Answer: All of the above
  3. Which of the following methods can be used to estimate the discount rate?
    • Use the risk-free rate and the beta of the company.
    • Use the company’s historical return on equity.
    • Use the company’s credit rating.
    • All of the above
    • Answer: Use the risk-free rate and the beta of the company.

Answers:

  1. Market capitalization
  2. All of the above
  3. Use the risk-free rate and the beta of the company.

Here are some additional points about estimating inputs in DCF valuation:

  • The FCFs should be estimated using a consistent methodology and assumptions.
  • The discount rate should be based on the riskiness of the investment and the return that investors require for similar investments.
  • The inputs to a DCF valuation should be reviewed regularly and updated as needed.