Calculate REITs DCF terminal value in 5 steps

In this blog post, we are going to talk about calculating REIT’s current intrinsic value using these 5 steps:

  1. Calculate WACC. 
  2. Calculate the present value of  Free Cash Flows during the explicit forecast period. 
  3. Forecast an estimate of the terminal value
  4. Find the Trust’s Enterprise Value
  5. Calculate the REIT’s Equity Value

Step 1: How to calculate WACC?

Before we start, Gurufocus stock screener provides their calculation of WACC for free! 

What is the Weighted average capital of cost (WACC)? 

Cost of Capital is the minimum rate of return that a business must earn before generating value. The source Capital can be generated from both Debt and Equity. 

The weighted average is just mathematical formula to skew the minimum rate of return towards the required rate of return for either Debt or Equity.

For example Company ABC Cost of Capital is $10 thousand,

  • 30% is based on debt, with an interest rate of 6%
  • 70% is equity, Investors expect an ROI of 2%

Thus the WACC would skew closer toward 2% because it Investor’s ROI expectation contributed more towards the Cost of Capital.

 How is WACC Calculated?

  • Rd(Cost of debt)
    The cost of debt otherwise known as the weighted average interest rate is given in the quarterly earnings report or annual report.
  • Re(Cost of equity)
    Cost of Equity =Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)
    The risk-free rate is the government 6 months or 1-year T-bills interest rate. Beta is a measurement of the volatility of returns relative to the entire market. GuruFocus provides its calculation for free. The market rate of return. The average ROE of the REITs for the past 5 years.
  • TC(Effective Tax rate)
    TC=(Tax Expense) /EBT . Tax expense and Earning before Tax can be found in the income statement
  • E(Firm’s Equity) can be found on the balance sheet as Net assets attributable to Unitholders.
  • D(Firm’s Debt) Debt includes short-term and long-term debt. I prefer to use Total liabilities to simplify calculations.
  • V(Firm’s value) which is, V= E+D

Step 2: Calculate the present value of  Free Cash Flows during the explicit forecast period. 

What is the explicit forecast period?

We want to forecast the FCF of the REITs for the next 5 years. This 5 year period is also known as the explicit forecast period.

How to calculate the explicit forecast period?

Find Unlevered Free Cash Flow(FCF0) = Net income + Depreciation&Amortization – Change in Working Capital – Capital Expenditure.
Forecast Unlevered Free Cash Flow for the next 5 years

Actual Forecasted
FCF0 FCF1 FCF2 FCF3 FCF4 FCF5

There are many ways to forecast FCF. All of them will be inaccurate regardless of the complexity of the math behind the methods.

The easiest method to forecast is:

  • To calculate the past  5 FCF and get the average growth rate 
  •  Or using excel draw a scatter plot of all the past FCF growth rates and draw a best fit line. 
  • Or you can just assume a modest growth of 1%~5% for FCF.
  • After Forecasting Expected period of FCF, apply this formula to discount FCF back to the present value Formula:

Step 3: Calculate an estimate of the terminal value

What is REIT’s terminal value?

Terminal value is the anticipated value of an asset on a certain date in the future. 

How to forecast REIT’s terminal value?

There are 2 methods to forecast terminal value. Both methods would yield very different results.

Method 1 Perpetual growth method

There are 4 ways to estimate Petrual growth.

Pick 1 best fit out of the 4 Types of perpetuity methods available:

Model type Formula  Assumptions
Constant-growth Perpetuity Model
  • Return on investment is lower than WACC
  • Use to assume constant growth.
Value driver model
  • Return on new investment is higher than WACC
  • To be used if the company is expected to remain a competitive advantage
Convergence Model
  • Return on new investments equals the WACC
  • To be used in competitive industries that move to competitive equilibrium.
Aggressive(Gordon) growth formula 
  • Return on investments(Without investing) approaches infinity 
  • Unrealistic Not to be used

 

Since REITs are cashflow are predictable, stable, and usually positive; We can forecast the “Free Cash Flow” of the REIT at the end of a 5-year period and assume an indefinite growth to estimate the terminal value.

In practice, the financial analysis would regularly update their DCF model based on new information that was released.

Method 2 Exit multiple approaches.

This method is more frequently used in practice. This method assumes that the value of a business can be determined at the end of a projected period, based on the existing public market valuations of comparable companies. 

The formula for,  Terminal Value = EBITDA5 X Exit Multiple.

Again just like FCF, the Final year EBITDA is just a forecast. The chances of any expert forecast being correct are nearly zero. You can assume that EBITDA and FCF grow at the same rate.

Typically REITs used P/AFFO as a multiplier but you can use EV/EBITA, P/E or any other metrics as an Exit Multiple. We will assume that the exit Multiple will remain constant forever, thus we will use the latest  P/AFFO available. P/AFFO= Current market capitalization rate/ Adjusted fund from Operating income.

Step 4: Calculate the REIT’s enterprise value 

Enterprise Value= PV(Forecasted period)+PV(Terminal period).
This is the total value of the firm available to both debt and equity holders. 

Step 5: Calculate the REIT’s Equity Value

Equity value= enterprise value – net debt
Stock Price=(Equity value)/(OutStanding Shares)
the value that is left for shareholders after all obligations of debt have been fulfilled.