Discounted Cash Flow (DCF)

Question 1

What is a DCF?

Answer 1

A DCF valuation is a growth explicit investment method of valuation.

It is a valuation model that seeks to determine the value of a property by examining its future net income or projected cash flow from the property and then discounting the cash flow to arrive at an estimated current value of the property.

It is a form of income approach valuation and is used for a number of valuations where the projected cash flows are explicitly estimated over a finite period.

Question 2

Can you give us some examples where you might use DCF?

Answer 2

• Short leasehold interests and properties with income voids or complex tenures
• Phased development projects
• Over rented properties

Question 3

Run us through a basis methodology to find the value?

Answer 3

1- Estimate the cash flow (income less expenditure)
2- Estimate the exit value at the end of the holding period
3- Select the discount rate (rate of return to find future cash flows present value)
4- Discount cash flow at discount rate
5- Value is the sum of the completed discounted cash flow to provide the NPV

Question 4

What is the Net Present Value (NPV)?

Answer 4

It is the sum of the discounted cash flows of the project

A NPV can be used to determine if an investment gives a positive return against a target rate of return

When the NPV is positive, the investment has exceeded the investors target rate of return

When the NPV is negative, it has not achieved the investors target rate of return

Question 5

What is the Internal Rate of Return? (IRR)

Answer 5

It is the rate of return at which all future cash flows must be discounted to produce a NPV of zero.

The IRR is used to assess the total return from an investment opportunity making some assumptions regarding rental growth, re-letting and exit assumptions

Question 6

How to calculate the IRR?

Answer 6

1. Input current market value as a negative cash flow
2. Input projected rents over holding period as a positive value
3. Input projected exit value at the end of the term assumed as a positive value
4. Discount rate (IRR) is the rate chosen which provides a NPV of zero
5. If NPV is more than zero, then the target rate of return is met

Question 7

RICS Practice Information - Discounted cash flow valuations, November 2023

Answer 7

This is a practical global guide covering the use of DCF valuation.

It covers topics to include:
- Explicit DCF valuation versus the implicit method of valuation
- The context for applying explicit DCF methods
- Differences between the inputs for market value and investment value