It is usually a good idea to use several different valuation approaches in estimating the value of an asset. The various approaches can be grouped into two broad categories: absolute value and relative value. Absolute value, sometimes called intrinsic value, is determined through what is commonly called DCF analysis or DCF valuation.
The phrase “Discounted Cash Flow Analysis” aptly describes the technique, since it involves analyzing cash flows. The word “discounted” refers to adjusting the value of future cash flows rather than just adding them all up. This is done to find the present value of the cash flows. The formula takes into account the concept that it is more valuable to receive $1,000 today than at some point in the future. That is because $1,000 can be invested to earn a return. The DCF formula incorporates the time value of money by discounting, or reducing, the value of future cash flows by the amount of return that could be generated between the time of initial capital contribution and receipt of the future cash flow.
It is best to compare the value generated by the DCF model to those stemming from relative valuation approaches. Relative valuation involves comparing a subject property to other similar properties. The use of cap rates and gross rent multipliers are examples of relative valuation approaches. Comparing the absolute value obtained through DCF to valuations made through relative valuation can protect investors from getting caught up in real estate bubbles, especially when the DCF value is much lower than the values computed through relative valuation.
There are a few important points to note about relative valuation. In order to compare one property to another, there has to be a way to standardize the data points. By using multipliers of gross rent or net income, it becomes possible to compare projects of different sizes. For example, it would be difficult to compare a 50-unit property to a 60-unit property without standardization. For standardization to work properly, there must be uniform accounting treatment. For example, in relying on gross rent multipliers, it is essential to know whether a multiplier is based upon a multiple of gross rent or effective gross income. Similarly, cap rates are helpful only if it is made clear whether deposits to reserve accounts are included or excluded as an expense in computing net operating income.
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