The discounted cash flow method determines a resale price or capitalization rate based on the market comparison method. As the price, the resale price or capitalization rate should not be determined by market comparison.
The price, or the capitalization rate, and all the resale prices to infinity in time must all be calculated based on the expected future cash flows. What can be calculated should not be determined by comparison to past prices, for the two prices will contradict each other.
Being an incorrect valuation system, the discounted cash flow method will have difficulty in determining the discount rate from past sales data. The problem is further aggravated by the requirement that discount rates should be different for cash flows from different sources or years.
In the absence of a correct solution of value, the market price has been almost always wrong, as evidenced by our chronicle financial crises, but it appears to oscillate around the correct price because of the "invisible" market force of supply and demand or "the invisible hand." Without the solution of value, the market price is formed by the competing forces of the invisible hand and market instabilities, such as over-valuation and under-valuation due to the Finite Spreadsheet Instability, which occurs when an investment is considered in a finite, not infinite, time frame where the change in price feeds back on itself causing the change to exaggerate. Thus, a correct valuation system should make the invisible hand visible and be able to estimate the rates of return for the real estate market with sufficient accuracy. July 18, 2009
October 24, 2009 Additional Update
The only time the market comparison method can be used is if the following two conditions are satisfied:
(1) the future expectation is unchanged and
(2) the past sales data are correct or have been correctly determined by a correct method of valuation.
Condition (1) is generally not satisfied, for change is the rule, not the exception. If Condition (2) can be satisfied, the correct method should be used at all times, not the market comparison method. If condition (2) cannot be satisfied, the market comparison method would just be a process of "the blind following the blind" until everyone falls off a cliff, as in a financial crisis.
There are three commonly used methods of Discounted Cash Flow: (1) Discounting with one constant discount rate for all cash flows to infinity in time, as used on page 34 of the book "Theory of Value" by Gerard Debreu, (2) Discounting with different discount rates for each and every year, and (3) Discounting cash flows and the cash from resale within a finite investment periods with one discount rate, as used by Discounted Cash Flow Method For Valuation by Argus Financial Software.
Method (1) is incorrect, because the discount rate should depend on the length of the investment. Method (2) is conceptually correct, but unusable for market comparison. The discount rate, similar to the rate of return, should be an approximate time-invariant. Having several discount rate for each and every year defeat the purpose of market comparison, with just one approximate discount rate. Method (3) is fatally flawed because the comparison of the resale price of the resale capitalization rate is as wrong as the market comparison method for the price.
The seemingly simple concept of discounted cash flow or present value is an abstraction and runs into an impossible situation when it is used to simulate reality. The reality, in contrast to abstractions, is unique and can always be followed.
The Infinite Spreadsheet follows reality and avoids abstractions by accounting the expected cash flows in a realistic fashion, as suggested by Benedict Spinoza, who was one of few a completely independent deep thinkers. The cash flows and the cash from resale are summed up and equated to an expression involving a averaged rate of return over the investment period. The resale price for determining the cash from resale are determined exactly the way the price is determined above. This formulation must extend to infinity in time in order to have the equal number of equations and unknowns, that is that to be deterministic. The methodology is fully disclosed in the patent "Quantitative Supply And Demand Model Based On Infinite Spreadsheet" (Pat. No. 6.078,901) by Post-Science Institute.