Stock Valuation , Discounted Cash Flows

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Stock Valuation

Section: 2 Discounted Cash Flows

Intuitively, the value of any asset should be a function of three variables: how much the asset generates in cash flows, when these cash flows are expected to occur, and what uncertainty is associated with these cash flows. Discounted cash flow valuation brings all three of these variables together by computing the value of any asset to the present value of its expected cash flows:

		t = n
Value	=	Σ	CFt
		t = 1	(1+r)^t

Where:

n	=	Life of the asset
CFt	=	Cash Flow in period t
r	=	Discount rate reflecting the riskiness of the estimated cash flows

The cash flows vary from asset to asset – dividends for stocks, coupons (interest) and face value for bonds, and after-tax cash flows for real projects. The discount rate is a function of the riskiness of the estimated cash flows; riskier assets carry higher rates, safer projects carry lower rates.

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