Discounted Cash Flow

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Literature Review of DCF
An important consideration when using the DCF approach to valuation is its validity and usefulness in valuing companies and their stock prices. Various studies have established that a strong correlation between estimated future cash flows and the value of a firm exists (Copeland et al, 1994 ; Brealey and Myers , 2000; Jones, 1998 ). In their study of 51 highly leveraged transactions (HLTs) , Kaplan and Ruback (1995) found that the valuations using the DCF methods are within 10%, on average, of the market value of the transactions, providing a strong relation between the market value and discounted cash flow forecasts. In addition, they found that the DCF methods perform at least as well as the comparable valuation methods. Comparing valuations using the Adjusted Present Value (APV) approach to those using comparative valuation methods, 47.1% to 62.2% of the APV valuations had valuation errors within 15%, compared to 37.3% to 57.9% using comparable valuation methods. Furthermore, after calculating an implied discount rate that forces their DCF forecasts to the market values, they obtained an implied market equity risk premium that is comparable to the historic arithmetic average market equity risk premium, suggesting the accuracy of the DCF method. Other studies have confirmed their findings, as per (Penman and Souginannis, 1998; Francis, Olsson and Oswald, 2000; Berkman, Bradbury and Ferguson, 2000; Gilson, Hotchkiss and Ruback, 2000).

However, according to Shiller (1984), stock prices moved in a direction opposite from the dividend price ratio. Another outcome of his research reflects that stock price volatility is too high to be caused by news about future real dividends. The research does not support the dividend discount model of predicting firm value as volatility in stock price cannot fully be explained by growth in future dividends.

In their study, Kaplan and Ruback valued the cash flows using a discount rate...
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