02 Oct Capitalization of Earnings vs. Discounted Cash Flow Model: Which to Use?
Written by: John Milnes, CVA
(3 – 5 minute read)
When reviewing business valuations, it is important to understand the valuation methodologies used within the report. Two of the most fundamental income approach methods include the Capitalization of Earnings method and the Discounted Cash Flow method. The choice to utilize either one of these methodologies depends on various factors, which will be discussed below.
Important Considerations
The first step in deciding which approach best fits the company being valued is to analyze the company’s historical performance. Certain businesses may reflect stable and predictable earnings year to year, while other businesses may fluctuate. It is important to understand which years are outliers and which years reflect typical operations. In addition to analyzing the company’s historical performance from year-to-year, it may be necessary to analyze the company’s performance on a month-to-month basis to gain a better picture of the business’s sales and earnings trends. Once it is determined what a typical level of sales and earnings are for a business, the appraiser can make a better decision on whether the Capitalization of Earnings method or Discounted Cash Flow method better fits the business being valued.
Capitalization of Earnings Approach
The Capitalization of Earnings method values a business based on its expected future earnings, capitalized at a certain rate based on economic, industry, and company-specific factors, referred to as the capitalization rate. This method works best for businesses with stable and predictable earnings. It involves dividing normalized earnings by the capitalization rate, which provides a straightforward calculation. Because it relies on historical earnings data and assumes that these earnings will continue, this method is most suitable for established businesses with consistent performance.
This approach is particularly useful when dealing with stable, mature businesses. It simplifies the valuation process when earnings are predictable and does not require complex forecasting. For example, a long-standing family-owned restaurant with consistent annual profits would be well suited for this approach given its stable earnings pattern.
Discounted Cash Flow (DCF) Method
The Discounted Cash Flow method, on the other hand, projects the future cash flows of a business and discounts them back to their present value using a discount rate. This method is more detailed and dynamic, accounting for the time value of money and the risk associated with future cash flows. It involves creating detailed forecasts of future cash flows and selecting an appropriate discount rate, making it more complex than the Capitalization of Earnings approach.
The DCF method is ideal for businesses with uncertain or fluctuating earnings or those with significant growth potential. It is particularly useful for long-term valuations and when a detailed analysis of future cash flows is needed. For example, if a business opened a new location or expanded its current location in the most recent year, it may be necessary to utilize the DCF method to account for the potential sales growth going forward. In this scenario, and many other DCF appropriate scenarios, it is necessary to obtain recent monthly sales to substantiate the projections provided from the buyer or seller. In the example below, a gym opened a second location in June which resulted in increased enrollment. Therefore, to capture the sales growth going forward, it would be prudent to rely on the DCF method, using the more recent monthly sales levels to project the base year revenues. If an appraiser were to incorrectly utilize the capitalization of earnings method in this scenario, the appraiser would only be accounting for a partial year of sales and earnings with second location.
Some other instances to utilize a DCF method would be the addition or subtraction of material clients, launching a new business product or service, being awarded a new contract with terms that differ from existing operations, or any other change in operations that would materially impact the sales and earnings of the subject business soon. It is important to keep in mind that these changes need to have occurred prior to the Effective Date and cannot be speculative changes. It is also beneficial to obtain projections to better analyze any expense fluctuations going forward, as some expenses can change based on future growth or reduction in sales. If projections are not available, the appraiser can rely on historical expenses and differentiate fixed and variable expenses accordingly.
Conclusion
It is key to understand the differences between these two income approach methodologies, and to make sure the appraiser completing the business valuation chooses the right one, as the approaches are mutually exclusive and both should not be relied upon in a single business valuation. If the historical financials can be weighted to reflect future operations, then the Capitalization of Earnings Method is likely the correct choice whereas, if the near future operations will differ from historical financials, based on already existing circumstances, then the Discounted Cash Flow Model is likely more accurate.