The discounted cash flow (DCF) model estimates a company’s value from the cash it is expected to generate in the future. Unlike dividend discount models (DDMs), it does not depend primarily on dividend payments, making it useful for valuing companies that do not currently pay dividends.
Investors buy shares with the expectation of receiving future economic benefits. These can include periodic cash dividends and the proceeds from selling the shares later. A sale at a price above the purchase price produces a capital gain.
All flashcards
What is a discounted cash flow model?
A valuation method that estimates an asset’s current value by discounting its expected future cash flows to the present.
What is the main focus of a DDM?
A dividend discount model primarily estimates stock value by discounting expected future dividends.
Why can DCF value a non-dividend-paying company?
It uses expected cash flows generated by the company, rather than requiring the company to distribute those flows as dividends.
What does absolute valuation mean in the context of DCF?
The company is valued on a stand-alone basis using its own projected cash flows and assumptions, rather than relying on comparison with other firms.
What is terminal value?
An estimate of the company’s value at the end of the detailed forecast period, representing value beyond that period.
Quiz questions
What is the primary basis of value in a DCF model?Answer: The present value of expected future cash flows generated by the company.
How does a DCF model differ from a dividend discount model?Answer: A DCF model values expected company cash flows, while a DDM primarily discounts expected dividends.
What makes DCF an absolute valuation method?Answer: It estimates value on a stand-alone basis using the company’s own projected cash flows and assumptions.
What does the discount rate represent in a DCF valuation?Answer: The required rate of return used to convert future cash flows into present values.
After estimating the total value of a company, how is an estimated value per common share generally obtained?Answer: Divide the estimated company value by the number of common shares outstanding.
Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.