Comparing two methods
Under the income approach, future cash flow drives value. Although that sounds simple, there are several methods that fall under the income approach, including discounted cash flow and capitalization of earnings. How do these two commonly used methods compare and which one is appropriate for a specific investment? Here are some answers to help clarify matters.
The International Glossary of Business Valuation Terms defines discounted cash flow as “a method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate.” In other words, this method entails these basic steps:
Compute future cash flows. In terms of cash flow, potential investors are generally trying to determine what’s in it for them and an acceptable return on investment. Often the starting point for estimating expected cash flow over a discrete discounting period of, say, five or seven years, is based on historical earnings. Then, the valuation expert calculates a terminal (or residual) value, which, in theory, represents how much the business could be sold for after the discrete discount period. (In reality, the business probably won’t be sold at that time, however.)
Discount future cash flows to present value. The valuation expert adjusts the cash flow forecast to present value using a discount rate based on the risk of the investment. If equity cash flows are computed in the first step, they’re discounted using the cost of equity. Conversely, if cash flows to both equity and debt investors are computed, they’re discounted using the weighted average cost of capital.
The value of the business is represented by the sum of those present values represents. The valuation professional may also need to subtract interest-bearing debt to arrive at the value of equity, depending on the nature of the expected cash flows that are discounted.
Fundamentals of capitalization
The same valuation glossary defines capitalization of earnings as “a method within the income approach whereby economic benefits for a representative single period are converted to value through division by a capitalization rate.” Although this sounds similar to the discounted cash flow method, it’s actually simpler. (Note: The term “earnings” typically refers to cash flow when valuation experts use this method, because capitalization rates are based on discount rates used in the discounted cash flow method.)
This method assumes that future cash flow will grow at a slow, steady pace into perpetuity, instead of calculating cash flows over a discrete discount period based on varying growth and performance assumptions. The method is based on the assumption that a single period (with modest adjustments for growth) provides a reliable estimate of what the business will generate for investors in the future.
As such, this method requires two simplified steps:
- Compute expected cash flow for a single period.
- Divide cash flow from the single period by a capitalization rate.
A critical component of this method is the long-term sustainable growth rate. Under the Gordon Growth Model — which is often used to value perpetuities — cash flow from a single period is multiplied by one plus the long-term growth rate. Then, the long-term growth rate is subtracted from the discount rate to arrive at a capitalization rate. Again, depending on the nature of the expected cash flow, the valuation professional may also need to subtract interest-bearing debt to arrive at the value of equity.
How to decide which method to use
Which method is more appropriate for a particular investment? In general, the discounted cash flow method provides greater flexibility if management expects short-term fluctuations in growth, revenue and expenses, leverage, working capital needs and capital expenditures. It’s particularly useful for high-growth businesses and start-ups that aren’t yet profitable — or when calculating damages over a finite period.
On the other hand, the capitalization of earnings method is often applied by established businesses with stable earnings because they generally find it easier and equally reliable. This method is also convenient when valuing a business for litigation purposes because it’s easier to explain to a judge or jury than a sophisticated discounted cash flow model. However, the discounted cash flow method is widely accepted in more sophisticated courts, such as the U.S. Tax Court or federal courts.
Expertise is essential
It’s critical to contact a credentialed valuation professional for more information on how these methods work. They can help you decide whether these methods are right for a particular investment.