Calculate REIT’s Intrinsic Value using DCF model 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, I would like to say that many stock screener like Gurufocus 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 toward the Cost of Capital.

 How is WACC Calculated?

  • Rd is the Cost of debt
    The cost of debt is otherwise known as the weighted average interest rate.
  • Re is the Cost of equity. There are two ways to calculate the Cost Of Debt, CAPM & Dividends Capitalization Model

Cost of Equity =Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)

      1. Take the Risk-free Rate of return as the 10-year Treasury Yield Return.
      2. Beta is a measurement of volatility. Use the value provided by the stock screener like yahoo or google finance as default.
      3. Market Rate of return takes the S&P500 10-year annualised returns as default or any other broad market index like MSCI.

Dividends Capitalization Model

  • TC is the Effective Tax rate
    Tax expense and Earning before Tax can be found in the income statement
  • E is the market value of the firm’s Equity. This is also known as Market capitalization (Market Cap).
  • D is the market value of the firm’s debt or we can use the book value of debt as a simple substitute.

Market Value of Debt

          1. C is interest expense in $
          2. Rd is the cost of debt in %
          3. T is the weighted average maturity in years
          4. FV is the total debt value at maturity in $
Book value of debt

Book Value of Debt=Long Term Debt + Short Term Debt

  • V(Firm’s value)which is, V= E+D.

Step 2: Calculate the present value of Explicit Forecast Free Cash Flows

Unlevered Free Cash flow is the current Free Cash flow of the company. What we NEED is just the sum of the forecasted Unlevered Free Cash flow. However, before we can learn to forecast FCF, we need the know the formula for unlevered FCF.

Unlevered Free Cash Flow(FCF0) = Net income + Depreciation Amortization – Change in Working Capital – Capital Expenditure

Now that we got this, let’s continue we Explicit Forecast period.

What is the explicit forecast period?

The Explicit Forecast Period is just the Sum of the expected FCF of the company for the next 5~10 years. This 5~10-year period is also known as the explicit forecast period. The further away your forecast the less accurate it will be. Hence, all professionals update their model input after every earnings call.

How to calculate the explicit forecast period?

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:

  • Assume the 10-year historical annualised growth rate remains true
  • Use arithmetic average annualised growth rate
  • Geometric average annualised growth rate
  • ordinary least squares linear or Non-linear regression models

Get the present value of the sum of all explicit forecast FCF.

After Forecasting the Expected period of FCF1, FCF2,….FCF5. Sum all the values together and discount them back to the present value.

The formula for the Sum of forecasted FCF discounted back to the present value:

Step 3: Calculate an estimate of the terminal value

What is REIT’s terminal value?

Just like the Forecasted Explicit forecast value, the Terminal value is the SUM OF ALL estimated Future FCF discounted back to present value.

The only difference between the Explicit Forecast Period & terminal value

  1. the difference in the time period. Whereby the explicit forecast period is the immediate future with a timeline of 5~10 years. While the Terminal value is after the explicated forecast period to infinity.
  2. expected growth rate. The Terminal period is expected to have a lower growth rate.

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
Constant growth Perpetuity Model:

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 = EBITDAX 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.

Step 4: Calculate the REIT’s enterprise value 

Enterprise value = (Forecasted FCF)+Terminal Value.

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

The value that is left for shareholders after all obligations of debt have been fulfilled.