Cost of Capital Using Discounted Cash Flow Approach
In finance, the discounted cash flow (DCF) analysis is a method of valuing a project, company or asset using the concepts of time value of money (Wikipedia, 2004). Three inputs are required to use the DCF, also called dividend-yield-plus-growth-rate approach, include: the current stock price, the current dividend, and the marginal investor’s expected dividend growth rate. The stock price and the dividend are east to obtain, but the expected growth rate is difficult to estimate (Ehrhardt & Brigham, 2011).
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The advantages and disadvantages of using DCF approach will be explained along with the further clarification on the cost of capital using DCF approach. The cost of capital is a term used in the field of financial investment to refer to the cost of a company’s funds, both debt and equity, or from an investors’ point of view, the shareholders required return on a portfolio of a company’s existing securities. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet (Wikipedia, 2004).
In other words, it is the expected return that is required on investments to compensate for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average, also called Weighted Average Cost of Capital (WACC). To value of any asset or business is a reflection of the present value of the benefits and liabilities of that asset or business. To use the DCF approach, add the firm’s expected dividend growth rate to its expected dividend yield. See the formula below: Rs=D1/P0 + Expected g
The discounted cash flow approach represents the net present value of project cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth. The concept of DCF valuation is based on the principle that the value of a business or asset is essentially based on its ability to generate cash flows for the providers of capital. The DCF relies more on the fundamental expectation of the business than on public market factors or historical precedents, and it is more theoretical approach relaying on numerous assumptions.
A DCF analysis yields the overall value of a business including both debt and equity (McClure, 2011). As previously mentioned, three inputs are required to use the DCF approach: current stock price, the current dividend, and the marginal investor’s expected dividend growth rate. The growth rate for use in the DCF model can be based on security analysts’ published forecasts, on historical growth rates of earning and dividends or the retention growth model.
If earnings and dividend growth rates have been relatively stable in the past, and if investors expect these trends to continue, the past realized growth rate may be used as an estimate of the expected future growth rate (Ehrhardt & Brigham, 2011). The retention growth model considers the fact that most firms pay out some of their net income as dividends and reinvest, or retain, the rest. The more they retain, the higher the earned rate of return on those retrained earnings, the larger their growth rate. A third technique used for marginal investor’s expected growth rate.
Analysts publish earnings’ growth rate estimates for most of the larger publicly owned companies. These growth rate summaries are often used as proxies for dividend growth rates. Of the three methods that can be used to estimate expected future growth, analysts’ forecast is the most logical. Studies have shown that these forecasts usually predict actual future growth better than the other methods. (Ehrhardt & Brigham, 2011). Some advantages of using DCF are that it is arguably the most sound method of valuation.
The DCF method is forward looking and depends more on more future expectations rather than historical results and it relies more on fundamental expectations of the business and is influenced less by volatile external factors. The DCF approach is focused on cash flow generation and is less affect by accounting practices and assumptions. A disadvantage of the DCF is that the accuracy of the valuation is highly dependent on the quality of the assumptions regarding marginal investor’s expected dividend growth rate.
The DCF model is only as good as its input assumptions, like any other valuation. DCF also works best when there is a high degree of confidence about future cash flows. The model is also not suited for short term investing (McClure, B. 2011). In summary, the discounted cash flow (DCF), or dividend-yield-plus-growth-rate, is a process used to estimate the cost of equity an investor expects to receive. It takes the dividend yield plus a capital gain for a total expected return.
Current stock price, current dividend and the marginal investor’s expected dividend growth rate are three inputs required to use the DCF approach. The stock price and current dividend are easy to obtain, however the expected growth rate is difficult to estimate. Three techniques used to estimate growth rate include: historical growth rate, retention growth model and analysts’ forecast. DCF analysis can help investors identify where the company’s value is coming from and whether or not its current share price is justified.
It is also the closest thing to a company’s intrinsic value. Another advantage of using DCF is that the current stock price is used instead of trying to come up with the fair value stock price. Disadvantages include the fact that the model is only as good as its input assumptions, it is hard to come up with the dividend growth rate and it is not suited for shore term investing. References Ehrhardt, M. C. , & Brigham, E. F. (2011). Corporate finance: A focused approach (4th ed. . Mason, OH: South-Western Cengage Learning. McClure, B. (2011). Pros and Cons of Discount Cash Flow Analysis. Retrieved on May 25, 2011 from http://www. investopedia. com/university/dcf/dcf5. asp). Macabacus (2011). Discount Cash Flow Analysis. Retrived on May 25, 2011 from http://www. macabacus. com/valuation/DCF/terminal-value. html. Wikipedia: The free encyclopedia. (2004, July 22). FL: Wikimedia Foundation, Inc. Retrieved May 17, 2011, from http://www. wikipedia. org