Why Does DCF Undervalue Equities?

14 Pages Posted: 4 Dec 2015

See all articles by Jacob Oded

Jacob Oded

Tel Aviv University - Coller School of Management

Allen Michel

Boston University, Questrom School of Business

Date Written: November 23, 2015

Abstract

Academics and professionals frequently use the yield to maturity (YTM) as a proxy for the cost of debt when valuing firms using discounted cash flow (DCF). This paper demonstrates that this practice is incorrect because YTM is calculated based on promised cash flows, whereas the traditional DCF valuation of firms is based on expected cash flows. The correct cost of debt in DCF valuations of firms is the expected return on debt. Valuations of firms that use the YTM as the cost of debt underestimate the correct value. This distortion is particularly large for highly levered firms where the difference between YTM and expected return on debt is sizable. These results are demonstrated using the recent highly publicized leveraged buyout of Clear Channel Communications Inc. We show that if YTM rather than expected return on debt were used in the valuation process, the price offered for the shares would have significantly underestimated their fair value.

Suggested Citation

Oded, Jacob and Michel, Allen, Why Does DCF Undervalue Equities? (November 23, 2015). Journal of Applied Finance (Formerly Financial Practice and Education), Vol. 19, No. 1&2, 2009, Available at SSRN: https://ssrn.com/abstract=2694724

Jacob Oded (Contact Author)

Tel Aviv University - Coller School of Management ( email )

Ramat Aviv
Tel-Aviv, 6997801
Israel

Allen Michel

Boston University, Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA MA 02215
United States

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