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Damodaran on Valuation: Security Analysis for Investment and

Corporate Finance, Second Edition
By Aswath Damodaran
Copyright © 2006 by Aswath Damodaran

Discounted Cash
Flow Valuation

n discounted cash flow valuation, we begin with the premise that the value of an
I asset is the present value of the expected cash flows on the asset. Since it lies at the
heart of all valuation approaches, the next five chapters will be dedicated to exam-
ining the estimation issues and the application challenges in using discounted cash
flow models.
In Chapter 2, we begin by looking at how best to estimate the cost of equity, the
cost of debt, and the overall cost of capital for a firm. In the process, we take a
quick look at the different risk and return models in finance and their underlying as-
sumptions and at the best estimation practices in estimating parameters for these
In Chapter 3, we turn our attention to the estimation of cash flows. We start by
considering the adjustments that we have to make invariably to the reported ac-
counting earnings for a firm to update and normalize them and to make them con-
sistent. We then look at the tax rate that we should use in estimating cash flows and
what items should and should not be considered when estimating reinvestment.
In Chapter 4, we examine different ways of estimating growth. After pointing
out the limitations of historical and management (or analyst) estimates of growth,
we link the expected growth of a company to its reinvestment policy—how much it
reinvests and how well it reinvests. We also consider how best to estimate the termi-
nal value at the end of the estimation phase.
In Chapter 5, we look at equity valuation models, beginning with the dividend
discount model and comparing its results to a free cash flow to equity model.
In Chapter 6, we present a range of firm or business valuation models, begin-
ning with the cost of capital approach but also including the adjusted present value
and excess return models. While we show that the models deliver equivalent results,
we consider the pluses and minuses of each one.