Using the Discounted cash flow (DCF) method to value farmland proves to be an accurate measuring stick to determine an accurate and fair price
What is the Discounted Cash Flow method?
The DCF method essentially it tries to value the asset at the present day value of expected cashflows. To do this we have to discount future cashflows at a set rate for a period of time.
What is the discounted part?
A discounted rate is applied because it allows the future expected cashflows to be accurately valued in todays dollars. It is discounted because future projected income is worth less then income earned today. This concept is the time value of money. It can also act as a measuring stick to the opportunity cost or riskiness of the investment. In farmland, and this example, our initial discount rate will be 7%. This represents potential interest on a land loan or the average percent gained in the stock market (alternate investment), or even inflation.
EXAMPLE
- 100 acres of land
- Cash rent of $100 per acre that increase by 10% yearly
- Holding time of 30 Years
- Expected initial Income of $10,000
- Taxes 1.1%
- Discount Rate 7%
As you can see above after 30 years our present value of cashflows is $727,000, however this does not take into account our discount rate. Our discounted cashflows only result in expected value of $242,000. If our land was 100 acres this values an acre at around $2424 dollars. Much lower then anyone would want to see. However, this fails to take into account the growth of our asset over time.
After reading this Purdue research article breaking down the valuation of farmland, it recommended 2 solutions to account for growth in land value. First, using the USDA's numbers for Missouri its estimated that farmland prices appreciated around 7.5% a year. It then suggest following the formula ((1+D/1+G)-1)=D* or (1.07)/(1.075)-1=-.0046 = -.5%. Another method is simply to calculate the expect growth in land value from the discount rate (7%). Both methods give us a new, lower discount rate of around -.5%. With this new discount rate our discounted cashflows have significantly increased to an asset value of $798,000.
Meaning, if you account for the appreciation in land an acre is actually worth around $7,986.
Take a read through my sources and let me know what you think!
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