Discounted cash flow vs. capitalization of earnings
How two methods measure up
Future cash flow drives value under the income approach. That sounds simple, but there are several methods — including discounted cash flow and capitalization of earnings — that fall under the income approach. 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. Potential investors are generally trying to determine what’s in it for them in terms of cash flow and an acceptable return on investment. Historical earnings are often the starting point for estimating expected cash flow over a discrete discounting period of, say, five or seven years. 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. Once cash flows have been forecast, the expert adjusts them 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 sum of those present values represents the value of the business. Depending on the nature of the expected cash flows that are discounted, the valuation professional may also need to subtract interest-bearing debt to arrive at the value of equity.
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.” This sounds similar to the discounted cash flow method, but it’s 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.)
Instead of calculating cash flows over a discrete discount period based on varying growth and performance assumptions, this method assumes that future cash flow will grow at a slow, steady pace into perpetuity. 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:
The long-term sustainable growth rate is a critical component of this method. 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.
The big decision
So, 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, established businesses with stable earnings may generally find it easier and equally reliable to apply the capitalization of earnings method. 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.
For more information on how these methods work, contact a credentialed valuation professional. He or she can help you decide whether these methods are right for a particular investment.
Sidebar: Understanding terminal value
Terminal (or residual) value is “the value as of the end of the discrete projection period in a discounted future earnings model,” according to the International Glossary of Business Valuation Terms.
Ironically, though it’s part of the discounted cash flow method, terminal value is usually calculated using the capitalization of earnings method. The theory is that cash flows eventually stabilize once a business matures. In theory, terminal value may also be computed using the cost or market approach, however.
In many cases, terminal value represents a large chunk of the cash flows that are discounted to present value under the discounted cash flow method. So, it’s important to compare terminal value to the results of other valuation approaches to gauge whether it seems reasonable.
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