Valuation and arbitrage

Summary

The use of discounted cash flow (DCF) methods in investment valuation and appraisal is argued by many academics as being rational and more rigorous than the traditional capitalization model. However, those advocates of DCF should be cautious in their claims for rationality. The various DCF models all rely upon an all‐encompassing equated yield (IRR) within the calculation. This paper will argue that this is a simplification of the risk perception which the investor places on the income profile from property. In determining the long term capital value of a property an ‘average’ DCF method will produce the ‘correct’ price, however, the individual short term values of each cash‐flow may differ significantly. In today's UK property market, where we are facing a period in which prices are not expected to rise generally at the same rate or with such persistance as hitherto, investors and tenants are increasingly concerned with the down‐side implications of rental growth and investors may indeed be interested in trading property over a shorter investment horizon than they had originally planned. The purpose of this paper is therefore to bring to the analysis a rigorous framework which can be used to analyse the constituent cash flows within the freehold valuation. We show that the arbitrage analysis lends itself to segregating the capital value of the cash flows in a way which is more appropriate for financial investors.

Keywords:

• internal rate of return
• equated yield
• freehold valuations
• discounted cash flow