Discounted Cash Flows and CAPM
- The basic theory underlying fundamental valuation is based the notion of discounted cash flows.
- The value of a stock (a bond, real estate, or any assets) is the sum of the income (cash flow) you expect to get in each future year discounted at the discount rates for those years.
- The discount rate is comprised of the riskiness of cash flows and the riskfree rate.
- The most commonly used method for determining the risk rate or the discount rate for stocks is the Capital Asset Pricing Model (CAPM).
- CAPM - the discount rate is R = Rf + Beta*Rp
- Rf is riskfree rate
- Rp is called risk premium (historically about 5.5% - 6.5%)
- Beta is a measure of the volatility of the return of the stock relative to that of the return of the market.
V -- the value of the stock.