We often talk about traditional valuations versus DCF. But traditional valuations are DCF models too. We created a series of videos to prove it.
Traditional valuations (capitalisation and shortcut models) are just compressed visually and mathematically from the ‘chronologically explicit’ DCF models we see in the spreadsheets created by analysts.
In practice, both valuers and analysts tend to structure models in three broad ways:
- Capitalisation models A simple direct capitalisation of income into value using a yield.
- Chronologically explicit DCF models Every individual cash flow is modelled period by period and discounted separately.
- Shortcut DCF models A hybrid approach using valuation shortcuts and pre-built formulae to simplify explicit modelling.
These approaches may look different on the surface, but they are all built from the same mathematical foundations.
Models can be explicit about different things
‘Explicit Growth’ is different to ‘Chronologically Explicit’. One refers to the rent, the other refers to time. The layout aspect of the different models is really all about different ways of grouping time.
In addition, ‘chronologically explicit’ and shortcut DCF models can choose where to include growth:
- Forecast growth in the rent, then discount at a rate of return (explicit growth); or
- Discount an unchanging rent by a lower ‘growth implied’ yield (implicit growth)
It is the explicit inclusion or exclusion of growth that academics normally mean when talking about explicit versus implicit models.
This is an important distinction in capitalisation models. Since you’re not explicitly forecasting rent in capitalisation models you have no choice but to use a growth implied yield.
All that said we have chosen not to include growth in our example so that we don’t need to worry about this for now. The yield and return are the same.
Same valuation, different layouts
The series of short videos show how these three models relate to one another using one very simple example: A property with a perpetual (forever) income of £100,000 per year discounted at a 10% return.
The capitalisation model is the easiest to reproduce:
Can we keep the value intact and ultimately prove all three models are fundamentally the same mathematically?
There are four videos in the series:
- The Present Value
- The Return
- The Annuity
- The Shortcut DCF
Let’s start with the fundamental building block of all the models, the discounting formula, also known as the Present Value.
The Discounted Cash Flow: The clue is in the name.
All three models calculate the ‘present value’ of all future cash flows, whether you can ‘see’ the model actually doing it or not. They then add up the discounted cash flows to generate a single mega ‘present value’. This single present value is the value of the property.
Calculating present values from a sequence of cash flows is called discounting. Before we understand the different models, we need to understand exactly what discounting is and how to discount cash flows using the present value formula.
Present Value Video
An extra bonus video, if you need it, peels the ‘Present Value’ formula back one layer further to the ‘Compound Growth’ formula. Watch this video if you need a refresher.
Compound Growth Video
The Discount Rate: the ‘Return’.
To discount a sequence of cash flows we need to know what (percentage) to discount the cash flows by.
In a cash flow with no prospect for growth the rate used in the ‘chronologically explicit’ cash flow (the return) is different to the rate (the yield) used in capitalisation models. This is because growth causes the return later in the cash flow to be better than the return at the beginning of the cash flow causing yield and overall return to diverge. Obviously growth is great but income growth adds a complexity to cash flows not needed for a discussion purely on layout. That’s why we have chosen a hypothetical investment that doesn’t have any growth.
In the video we generate a ‘chronologically explicit’ cash flow with a 10% return: £100,000 income given a purchase price of one million pounds.
So, here’s the question: If we discount the cash flows at 10%, will we get the same value i.e. one million pounds, regardless of how long we hold the investment for? Watch the video to find out:
The Return Video
Discounting blocks of income: The ‘Annuity’ formula.
The long models we have shown you so far are the ‘chronologically explicit’ cash flows. All this means is we explicitly discount every cash flow, one by one, over the holding period. This is what Analysts working for property funds do because it allows them to focus on detailed rent projection.
But this is the important bit: If we want to transition from a ‘chronologically explicit’ model to a shortcut model then we need to know how to discount an entire sequence of cash flows in one go.
This one-shot discounting formula is called the ‘Annuity’, and it is the link between chronologically explicit and shortcut models.
Watch this next video to find out what the annuity formula looks like and how we can use it to make DCF models more concise.
The Annuity video
The Shortcut DCF
Now we have all the tools we need to compare a ‘chronologically explicit’ DCF with a shortcut DCF.
Watch the video below to see the two models explained side by side so that you compare layouts along with their identical valuations of one million pounds.
Shortcut DCF Video
Summary
Hopefully we have proved beyond doubt that all models: capitalisation, chronologically explicit or shortcut, are generated from the same discounting mechanism. They are just presented in different ways. The ‘no growth’ example we used throughout allowed us to declutter from the issue of yields versus return.
However, where growth is expected, then finding the right yield that matches the right return is trickier (the Gordon Growth models, sometimes but not always, does the trick) but the valuation, regardless of the layout, should still be the same. If it isn’t the issue is a computational one not market or perspective driven.
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A final thought on traditional valuations
The shortcut DCF is compact. For this reason, it is also used in traditional valuations where growth, risk and return in the term and reversionary income, rather than cash flow detail, are the focus of the valuation. These were called term and reversion valuations long before they could also be identified as shortcut.
Shortcut valuations can be implicit or explicit with respect to growth but that’s the topic for another time.
If you’re interested in models analysing growth investments, you can read Natalie Bayfield's paper on fully explicit DCF models here: https://www.preprints.org/manuscript/202503.1068