Why Does DCF Undervalue Equities?

Jacob Oded, Allen Michel

Research output: Contribution to journalArticlepeer-review


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.
Original languageEnglish
Pages (from-to)49-62
Number of pages14
JournalJournal of Applied Finance
Issue number1/2
StatePublished - 1 Mar 2009


  • Discounted cash flow
  • Business valuation
  • Yield to maturity
  • Cash flow
  • Expected returns
  • Valuation
  • Valuation of corporations
  • Stocks (Finance)
  • Capital costs
  • Leveraged buyouts
  • Fair value
  • Clear Channel Communications Inc.


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