Discounted-Cash-Flow Value Estimates are Optimistic when Assumptions are Not

35 Pages Posted: 5 Jun 2020

See all articles by Hendrik Bessembinder

Hendrik Bessembinder

Arizona State University; W.P. Carey School of Business

Date Written: June 2, 2020

Abstract

Discounted-cash-flow valuations are upward biased even when estimates of market discount rates and cash flow growth rates are unbiased, because both compounding and discounting are convex functions. The upward bias in the estimated value of a long-lived cash flow stream can exceed 25% under plausible assumptions regarding magnitudes of estimation errors, which can equate to upward bias in estimated net present values that exceed 100%. This bias may help to explain the value premium puzzle, observed takeover premia, long run returns after IPOs, and high equity valuations during periods of low real interest rates. A method of correcting value estimates for the bias is proposed.

Keywords: Value Estimation, Discounted Cash Flow, Net Present Value, Bias

JEL Classification: G11, G12, G31, G34

Suggested Citation

Bessembinder, Hendrik (Hank), Discounted-Cash-Flow Value Estimates are Optimistic when Assumptions are Not (June 2, 2020). Available at SSRN: https://ssrn.com/abstract=3617355 or http://dx.doi.org/10.2139/ssrn.3617355

Hendrik (Hank) Bessembinder (Contact Author)

Arizona State University ( email )

PO Box 873906
Tempe, AZ 85207
United States

W.P. Carey School of Business ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

HOME PAGE: http://https://wpcarey.asu.edu/people/profile/2717225

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