The Royal Institute of Chartered Surveyors (RICS) recently released the Independent Review of Real Estate Investment Valuations report, in which one of the recommendations was that Discounted Cash Flows (DCF) should be used as the main valuation approach, when valuing Commercial Real Estate assets.
The background of DCF
The method was first conceptualised back in the 1930’s by well-known economist John Burr Williams, who defined the ‘Theory of Investment Value’ which considers that the intrinsic value of a company is equal to the present value of its future dividends, rather than its earnings.
This was later built on by Myron Gordon in the 1960’s when he introduced growth to Williams’ model by developing another method for evaluating stock and companies based upon his own theory ‘The Gordon Growth Model’ which assumes that as companies continue to grow, dividends would too.
Fast forward to today, and DCF is now extensively used in many markets across the globe for CRE appraisals, including in the UK. It has shown itself to be a flexible yet explicit tool for both transactions and valuations.
When you should use DCF:
The first step in realising when to use DCF is by ensuring that your valuation technique reflects the market approach for the pricing of that asset. Even if DCF isn’t used as the primary approach in your market, you should still consider using it as a supporting approach and for additional analysis.
Many investments are traded on a DCF approach - therefore a DCF is always going to be the most appropriate method.
Many other investments are either purchased on a more traditional basis or a DCF, depending often on the purchaser type - the use of a DCF appraisal, especially as a check or for the analysis of a traditional approach, is a powerful addition.
Trade related properties, specialist properties, situation where debt is reflected in the appraisal, or when appraising value to a particular owner (worth) should almost exclusively be appraised using a DCF approach.
Even in situations where you might not use it, use it for additional analysis to improve transparency.
The opportunities with adopting DCF:
Adopting this more direct methodology will offer greater transparency to your calculations and provide an enhanced framework for more considered advice and business planning. While DCF will use more explicit inputs than traditional approaches, many of the inputs will be very familiar.
DCF also provides opportunity around risk management, as there is greater visibility of the data involved. Using DCF alongside other approaches only enhances the likelihood of being able to identify inaccurate data.
It also offers the opportunity for the valuation industry to increase engagement with other professionals, as it is a widely recognised concept both globally and across different fields.
Adopting a new method may seem daunting at first, however DCF builds on the existing, more traditional, techniques that you will already be familiar with.
Jeremy Handley, Director at Polgrain Consulting Ltd. Says, “Valuers are already instinctively considering many of the factors which are reflected in DCF, the real difference in my mind is that with DCF you’re going to be much more explicit about those factors. It doesn’t really feel like a different technique, but more about taking those instinctive assessments you’re already making and turning them into numbers in a cash flow.”