In Albany v Commonwealth of Australia (1976) 12 ALR 201 the High Court was asked to address a number of valuation problems, for compensation purposes for a large parcel of land east of Darwin. The context of the case is important. The area of the subject land was large, 4508 acres. The purpose of the acquisition was "the planned development and control of the City of Darwin and its adjacent areas"(203). The plaintiff claimed that the acquired lands had a highest and best use of urban and residential development. (1612+2896acres)
The value claimed of $8 500 000 was upon the basis that the best use of the land at the date of acquisition was for urban development, mainly residential but also including some commercial and industrial areas. Assumed that the land could be subdivided into 6*20 acre lots plus 11 930 lots of residential land together with sites for shopping centres, schools and open space (205/6). They valued the land using DCF using a discount rate of 25%. Using that method of valuation a value of $8 477 000 was arrived at. Jacobs J said about DCF:
The process of discounted cash flow is one which is known as a method of estimating present value of a capital asset in accounting processes. It is not a process which had previously been used by any of the plaintiff's valuers in the valuation of land. It is a process known to one of the defendant's valuers, Mr F, although he did not consider it an appropriate method in the present case(206).
Commenting on the treatment of costs:
..the estimate of incomings and outgoings in the projected number of years of development takes account of the estimated rise in the value of the land over the period and the estimated increase in development costs over that period. The figures selected by the plaintiff's valuers in this connection are an 8% rise per annum in the price of land sold and a 6% rise per annum in development costs. In this respect particularly, factors are introduced into the subdivisional projection which are not present in the commonly adopted method of valuation on the basis of a hypothetical subdivision. Sale prices of the subdivided land and cost of development of the land are taken in to calculation at current values. A profit and risk factor is calculated as a matter of judgement based upon comparable developments. (206)
He then compared DCF with the traditional hypothetical development method and noted that the additional information that is required in DCF is a projection of future rises in land prices and development costs. (207) His honour agreed that the land was ripe for development as the most probable site of the new town and that a developer would have been aware of that fact at the date of acquisition and would have treated it as a high probability. (210). However, there is great uncertainty about the length of time between consideration of the concept and when the authorities would have actually allowed the subdivision to take place. Therefore, although the land has high development potential it would in all probability be some time after the date of acquisition. (210) Jacobs J then analyzed the use of DCF in valuation:
I should now say that I am not satisfied that this could be an acceptable method of valuation in the present case. I express no opinion upon the question whether or not, in other circumstances and in other cases, a method of valuation by way of discounting the anticipated cash flow is a proper method of valuation of land. ....There is no evidence that the application of this method has either in theory or in experience produced results consistent with methods of valuation upon the basis of hypothetical subdivision which has, where necessary, been applied in the past"(210)
Great play has been made of the underlined part of Jacobs statement but unfortunately almost all the areas in which DCF is used has the similar speculative and forecasting error/doubt as in Albany. There are some areas where DCF is the best method of valuation and that is where the projected cash flow is known with reasonable certainty and these are the types of valuations that his honour is referring to.
He then analyzed the factors adopted in the DCF:
Time of starting and finishing. This is an important factor in DCF:
I conclude, therefore, that the turn-off of blocks would not have commenced until 1978"
This is a period substantially later than that envisaged in the DCF.
The number of blocks likely to be obtained in the subdivision. The blocks on the plaintiff's plan were too small for a tropical climate. After taking into account a number of factors necessary in the subdivision his honour concluded that the proper number should be about 9000 blocks as opposed to 11 230 proposed in the DCF.
The cost of development per lot. Held that the cost of development should be $5 000/lot and not $3 700/lot as proposed by the plaintiff (214).
Prices to be obtained: Held that about $6 700/lot on average is a fair and proper price. This gives a gross realization substantially less than that claimed by the plaintiff.
Period of time for sale: Agreed that the turn-off of the whole area by 1986 although optimistic is not "wildly optimistic" (216).
Rate of discount of the cash flow: Although not happy with the 25% discount rate, there was no other evidence available and reluctantly accepted that. (216)
It appears to me that even upon an assumption that a method of discounting cash flow is a method which can lead to an accurate valuation of land in circumstances such as the present, the plaintiff substantially fails to disclose a value by this method which approaches the value of approximately $8 500 000 claim to be revealed on the initial analysis of the plaintiff's valuers. Error has occurred by underestimating the time between the date of acquisition and the date when a turn-off of developed blocks might be expected, by underestimating the cost of development per block, by over-estimating the number of blocks, and by over-estimating the price likely to be obtained for each block"(216)
It would appear to be necessary in projections based on discounted cash flow to take account of rises in costs and likely rises in prices obtained. Rises in costs for the purposes of the analysis have been estimated at 6% per annum and rises in prices at 8% per annum. It is hardly necessary to remark that the basing of a present value upon projections of this kind could be very dangerous without allowing for a wide margin of error by means of a heavy discount factor". (217)
The plaintiffs then came back with an amended DCF which more accurately reflected the opinion of the Court. However, although better, it was still rejected by Jacobs J:
I have carried out this exercise in order to show how far wide of the mark was the initial valuation of the plaintiff's valuers because of incorrect assumptions made as the basis thereof. However, I would not consider it safe to adopt the indicated figure as a correct valuation of the lands, because I am not satisfied of the suitability in this case of a method of valuation based on discounted cash flow". (218)
Eventually his Honour determined value using comparable sales:
Nevertheless, the approach which I find most useful is the analysis made by Mr McD upon the basis of a sale of the land at the date of acquisition in 31 separate lots. This approach permits the individual examination of various areas depending upon their particularly locality, particular advantages and particular constraints. It makes more useful the evidence of the only truly comparable sales which are entirely, or almost entirely, to be found in the sales of the lots in Section 111 and the sales in the Churcher subdivision and, in addition, the sales of land adjoining or in close proximity to the Stuart Highway"(220)
His honour then analysed each of the sales in turn and in great detail. This included the valuation of the quarry lands. Upon the addition of the value of each of the parts a total valuation of $3 386 000 was derived at for the market value of the land.
AN ANALYSIS OF THE ALBANY CASE
The case well illustrates the problems facing a judge when a purported valuation includes a number of speculative elements particularly, when the DCF is very sensitive to those variables. The problem is really one of the quality or reliability of the evidence. Ultimately and typically, sales are resorted to which in this case are part of a comparatively simplistic analysis assumed in the hypothetical development method.
Sale evidence is higher quality evidence than a complex discounted cash flow because the DCF relies for its integrity on the reliability of a number of variables within the cash flow such as the period used (usually far too long) and the discount rate. If the variables within the DCF flow are reliable then prima facie, the DCF is also reliable.
Decisions in court cases are determined using the adversary system, a factor which those of us in valuation must never forget. All practising valuers deserve their day in court!
If one party puts up a valuation which incorporates speculative elements and the other party argues something concrete and direct such as the use of sales such as direct comparison with opportunity cost adjustments, the judge will always favour the more direct evidence.
Jacobs J in Albany could see the problem of unreliability of the important and sensitive variables in the DCF such as length of time, expected sale prices and costs. Further, without need of a more detailed examination he could see that there was a substantial difference in the value obtained by using the DCF compared to that obtained using more reliable valuation evidence.
Subjective probabilities when applied to components of the DCF take into account its temporal nature so that over time (the DCF period), the probability of correctness becomes less. On the other hand, the hypothetical development method is non temporal and therefore, in this case has a higher probability of being correct. This is not to deny that in some cases DCF is the best method with the highest probability of correctness for example, a short but complex development period on a vacant land. However, under the circumstances facing the judge in Albany the whole exercise had a high speculative content and therefore, a low probability of being correct.
Applying subjective probabilities to those parts of the DCF analyzed by Jacobs J the following schedule of probabilities can be constructed:
|DCF PROBABILITY||HYPOTHETICAL DEVELOPMENTPROBABILITY
to be obtained:
of time for sale:
This underlines the dilemma facing a valuer who wishes to employ DCF. Under the legal adversary system his valuation will be anaysed against and compared with that of the opposing counsel. If the opposing counsel uses a more traditional and direct method of valuation consisting of more reliable components the judge must accept the evidence of the traditional method in preference to the DCF method.