Discounted Cash Flow

Valuation methodology involving the projection of a series of cash inflows and outflows over a defined future period of time, utilising equal periods over the term of those cash flows. The process involves calculating the present value of the future cash flows by using an appropriate discount rate. The underlying principle to the DCF analysis is that the current Market Value is equal to the present value of all the future cash flows, taking into account the time value of money. The DCF method heavily relies on the internal rate of return (IRR) which reflects the total rate of return which an investor would expect to achieve from the investment over the cash flow forecast period. In determining an appropriate IRR, the market will generally take into account the returns available from alternative “risk free” investments such as Government bonds, inflation factors, the illiquidity risk premium generally attached to property and the asset risk premium attaching to the particular investment, however a certain degree of subjectivity is involved. Factors that limit whether a DCF is appropriate include the suitability of the method opposed to comparative methods of valuation, the availability of reliable information and criteria affecting the selection and application of a discount rate. The main detriment of a DCF analysis is that it relies on assumptions and projections and assumes a willing buyer at the end of the period. A DCF is most frequently used as a supporting valuation method for large office buildings, large shopping centres and residential subdivisions.