| Popis: |
The discounted cash flow valuation method relies on expected cash flows. But because they often ignore low-probability downside events, the forecasts of expected cash flows that are provided by corporate managers and analysts are often excessively optimistic, or upwardly biased. As a result, such forecasts need to be adjusted when used in valuations. Whereas academics generally prefer adjustments of the cash flow forecasts, practitioners typically account for such downsides by increasing t he discount rate above the market-based cost of capital. This article suggests that the appropriate adjustment to the DCF formula should depend on the nature of the omitted downside. The author shows that when the down side is assumed to be “temporary”— say, a large, weather-related loss—the appropriate adjustment to the DCF formula is to reduce the forecasts by the expected downside and set the discount rate equal to the market-based cost of capital. But when the omitted downside scenario is expected to be “permanent”—in the sense that the event reduces all subsequent future cash flows—the appropriate adjustment is to reduce the cash flows and increase the discount rate to reflect the probability that such a downside occurs. By endorsing both of these prescriptions, the author effectively acknowledges that there is a reasonable conceptual basis for both the academic approach of adjusting the forecasted cash flows and the practitioner approach of inflating the discount rate. The appropriate approach depends on the characterization of the omitted downside as either temporary or permanent. |
