Tuesday, January 20, 2009

Methods to Calculate Discount Rates - DCF

Discounted Cash Flow Analysis can be broken down into three sections:

1. Forecast free cash flows for a given period (5 to 10 years generally, and depending on the industry)
2. Discount free cash flows using some discount rate

3. Calculate the Net Present Value

A question you will probably encounter during interviews will be: What discount rate should you use when performing a DCF?

According to Wet Feet, you should know 4 different discounting methods: CAPM Model, WACC, Gorden Model, Hurdle Rate or Rule of Thumb.

1. CAPM Model - Calculating the return on equity (R
e)
--- R
e = Rf + Beta (Rm - Rf)
--- Beta is a measure of how sensitive the equity price is to the market (also known as market risk)
---
(Rm - Rf) is known as the risk premium (generally 5%-9% depending on your source information)

2. WACC (Weighted Average Cost of Capital)
--- WACC = R
e*E / (D + E) + Rd (1 - Tc ) *D / (D + E)
--- R
e = return on equity
--- R
d = return on debt
--- E = market value of the equity
--- D = market value of debt (usually assume equal to BV
--- T
c = corporate tax tate

3. Gordon Model
--- R
e = D1/P0 + g
--- D
1 = next years' expected dividend
---
P0 = today's stock price
--- g = the expected growth rate of dividends
--- this model assumes a constant dividend payout ration and dividend growth into perpetuity

4. Hurdle Rate or Rule of Thumb
--- Determine some rate of return - say 12% - and only accept investment projects or opportunities that exceed that rate

4 comments:

Anonymous said...

Thanks for your valuable information.

It was really of use to me.

Chenna

www.usjobcareer.com

The No.1 Job and Career Search Portal

Anonymous said...

Thanks for your valuable information.

It was really of use to me.

Chenna

www.usjobcareer.com

The No.1 Job and Career Search Portal

jody said...

I will definitely use this method. Thanks a lot!

jjb discount code

QUALITY STOCKS UNDER 5 DOLLARS said...

Interesting