Discounted Cash Flow Analysis
Discounted cash flow (DCF) analysis is an accepted analytical tool and method of valuation within the income capitalization approach to value. DCF is not a new method, but it did not enjoy widespread use until modern computer technology enabled appraisers to automate the process. Because DCF analysis is profit oriented and dependent upon the analysis of uncertain future events, it is vulnerable to misuse. What steps can the appraiser take to avoid misuse of DCF analysis?
The acceptance of DCF analysis as a method of valuation began in the institutional real estate market and has spread to investment real estate
in the general real estate market. DCF techniques may be applied in the valuation or analysis of proposed construction; land development; condominium development or conversion; rehabilitation development; and income-producing real estate of various types. DCF analysis is becoming a requirement of advisors, asset managers, fiduciaries, portfolio managers, syndicators, underwriters, and others dealing in investment-grade real estate. These users of appraisal services favor the inclusion of DCF analysis as a management tool in projecting cash flow and return expectations, capital requirements, refinancing opportunities, and timing of future property dispositions. DCF analysis is regarded as one of the best methods of replicating steps taken to reach investor buy/sell/hold decisions, and is often a part of the exercise of due diligence in the evaluation of an investment.
DCF analysis can be used for investment value and market value appraisals, as well as for other purposes such as sensitivity tests. DCF analysis is an additional tool available to the appraiser and is best applied in developing value opinions in the context of one or more other approaches. This statement focuses on the criteria for proper DCF analysis and does not imply that DCF analysis is or should be the only method employed.
To avoid misuse or misunderstanding when DCF analysis is used in an appraisal assignment to develop an opinion of market value, it is the responsibility of the appraiser to ensure that the controlling input is consistent with market evidence and prevailing market attitudes.
Market value DCF analyses should be supported by market-derived data and the assumptions should be both market- and property-specific.
They should be judged on the market support for the forecasts when made, not whether specific items in the forecasts are realized. An appraisal report that includes the results of DCF analysis must clearly state the assumptions on which the analysis is based and must set forth the relevant data used in the analysis.