When I was a young Valuer in training, the Discounted Cash Flow Method always seemed to be so intimidating. The mere mention of it still makes me cringe to this day. This despite having mastered it, pun intended, through a masters programme (MSc Real Estate) some years back. To put my mind at ease, I figured why not write more about the topic so that whenever I feel a cringe coming along, I can refer to my blog and see that it is in fact not as intimidating as I had once thought it to be.
The Discounted Cash Flow (DCF) is a valuation method that falls under the Income Approach as defined in the International Valuation Standards (IVS) Framework. The method is applied to a wide range of asset types/classes. It is a vital concept and can be regarded as the most important of all the techniques used in the finance industry.
The method encompasses determining present values, future values and analysing unequal and equal cash flow streams. This is done to determine the various financial measures of return.
When is it Used?
The DCF method can be used to value most assets that generate a cash flow. It may provide a better indication of value than other methods where:
- The asset or business is experiencing significant growth or has yet to reach a mature level of operation. Examples include new business ventures or an investment property under construction (e.g. include hospitality, retail centres, filling stations etc).
- Cash flows are likely to fluctuate from period to period in the short term, e.g. fluctuations to rental income generated by an investment property due to leasing terms and conditions or to a business’ income because of cyclical changes in demand for its products; or
- The asset has a limited life, e.g. assets and businesses in the energy and natural resource sector.
Principles of this Method:
The value of any asset is a reflection of the present value of the net benefits expected to be derived from that asset as of the specified valuation date. Although there are distinct terms and inputs used when applying the DCF method to valuations of real property and businesses, the basic principles of the method are the same.
The DCF method results in an indication of value whereby forecasted cash flows are discounted back to the date of valuation, resulting in a present value of the asset or business. A terminal value at the end of the explicit forecast period is then determined and that value is also discounted back to the valuation date to give an overall value for the asset or business.
Key inputs that are required for this method:
- Determination of the explicit period over which the cash flows will be forecast;
- Cash flow forecast for that period;
- The asset or business value at the end of the forecast period, i.e. the terminal value; and,
- The appropriate discount rate to apply to the forecasted future cash flows which includes the terminal value.
- Where cash flows are likely to fluctuate, the length of time for which changes in the cash flow can be reasonably predicted.
- The length of time to enable the business or asset to achieve a stabilised level of earnings;
- The life of the asset; or
- The intended holding period of the asset.
