Other REIT Valuation Methodologies: The Discounted Cash Flow or DCF. The steps to calculating a DCF are the same in a REIT as they are in a traditional corporate. First, we forecast free cash flows to steady state, which is normally five to 10 years. Second, we calculate the weighted average cost of capital, or WAC. Third, we calculate the terminal value, which is the value of the company beyond the forecast period. Fourth, we discount the cash flows back to today using the WAC. And fifth, since the DCF is an enterprise value valuation technique, we need to get from enterprise value to equity value all the way to an implied share price. There are three main differences in calculating a DCF for REIT compared to a traditional corporate. First is the use of AFFO, or adjusted funds from operations, instead of free cash flows. Many analysts believe that AFFO is an appropriate substitute for free cash flows as taxes do not factor in with most REITs. Secondly, we generally prefer the use of unlevered cash flows, such as free cash flow or AFFO, as they remove the choice of capital structure from the analysis. Secondly, we generally prefer the use of unlevered cash flows, such as free cash flows or AFFO, as they remove the choice of capital structure from the analysis. However, many consider the use of free cash flow to equity holders as appropriate for REITs as REITs have stable cash flow, stable balance sheets and significant leverage, which will impact the valuation. We need to consider that if we are using free cash flows to equity holders, we need to remember that if using free cash flows to equity holders, we would only use the cost of equity to discount those cash flows, not the WAC, as we would for the free cash flows to the entire firm. And finally, whichever method you are using, free cash flows to the firm or free cash flows to equity holders, you must account for equity dilution as shares must be issued to achieve any future growth in a REIT. Here's how we calculate free cash flow to equity holders as compared to free cash flow to the firm. For free cash flows to the firm, which are the traditional free cash flows, we start with revenues and we subtract our operating expense. We add depreciation and amortization. We add or subtract the changes in operating working capital. We subtract recurring or maintenance CapEx. We subtract any real estate acquisitions. We subtract any investment in real estate developments and we add the proceeds from any real estate sales. For free cash flow to equity holders, we start with the operating cash flow and then we add or subtract the investing cash flow. We add any issuances of common or preferred stock. We subtract any preferred stock dividends. We subtract any deferred financing fees. We add any debt borrowings and we subtract mandatory debt repayments. If you compare the two, you will see that for free cash flow to equity holders, by starting with the sum of the operating and investing cash flows, you have basically captured everything included in the free cash flow to the firm. The major difference is being the inclusion of interest expense in the cash flow to operations which we exclude in the free cash flows to the firm. Again, tax is not a factor with REITs. The calculation of free cash flow to equity holders reflects all of the demands on the net assets before the equity holders get their stake. In order to calculate a per share value in a DCF, we will need to divide the equity value by the diluted shares outstanding. Remember, in valuation, we are always using diluted. Calculating diluted shares outstanding in a REIT is tricky and should not be overlooked. It is more than simply factoring in options outstanding as in a non-real estate company REITs grow by issuing debt and equity. To build a DCF forecast would imply that some amount of equity is going to be issued in the future. We cannot rely on leverage alone. The equity issuance is typically forecast in line with the target capital structure. We then discount back the stock issuances in dollar value at the cost of equity. A terminal value will also be calculated based on a steady state equity issuance for the years beyond the forecast. The net present value of those issuances are then divided by the current share price to get the number of new shares that will be eventually diluting ownership. Now this is all theoretical, but the DCF is a highly theoretical and academic technique so it must be considered.
