Discounted Cash Flow Analysis - Empirical Study

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An empirical study of the discounted cash flow model
Martin Edsinger1, Christian Stenberg2 June 2008

Master’s thesis in Accounting and Financial Management Stockholm School of Economics

Abstract The purpose of this thesis is to compare the practical use of the DCF model with the theoretical recommendations. The empirical study is based on eight different DCF models performed by American, European and Nordic investment banks on the Swedish retail company Hennes & Mauritz (H&M). These models are currently being used internally by the corresponding equity research departments to determine the fair value of the H&M stock. The aspects that are studied are regarded as the basic theoretical requirements of the DCF model. The discrepancies between theory and practice are concluded to be significant and the overall quality of the studied DCF models is determined to be poor. The explanation for the differences between theoretical practice and empirical findings is mainly attributed to the use of the DCF model as a tool to merely motivate an investment recommendation and not derive a correct theoretical value. Tutor: Professor Peter Jennergren3 Discussants: Gustav Ohlsson, Fredrik Toll and Carl Wessberg Presentation: June 5, 2008, 15:15 am Venue: KAW, Stockholm School of Economics Key words: corporate valuation, discounted cash flow model, free cash flow, valuation

20084@student.hhs.se 20103@student.hhs.se 3 We would like to thank our tutor, Professor Peter Jennergren, for valuable guidance and support 1 2

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Table of contents
1. Introduction .............................................................................................................................................. 4 1.1 Purpose and contribution ................................................................................................................. 4 1.2 Delimitations ...................................................................................................................................... 5 1.3 Outline ................................................................................................................................................. 5 2. Data and methodology ............................................................................................................................ 6 2.1 Data...................................................................................................................................................... 6 2.2 Methodology....................................................................................................................................... 6 3. Theoretical framework ............................................................................................................................ 8 3.1 Analysis of historical performance .................................................................................................. 8 3.2 Forecasting future performance ...................................................................................................... 8 3.3 Estimating the cost of capital ........................................................................................................... 9 3.4 Estimating the continuing value .................................................................................................... 10 3.5 Other aspects .................................................................................................................................... 12 3.5.1 Financial cash flow ................................................................................................................... 12 3.5.2 Inflation...................................................................................................................................... 12 3.5.3 Excess marketable securities ................................................................................................... 12 3.5.4 Currency forecasts...
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