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The Income Approach Simplified. DCF v. Capitalization of Earnings Methods

Posted in Business Valuation, on Feb 2019, By: Mark S. Gottlieb

Recently, while testifying to the fair market value of a closely-held business, the attorney began off-scrip and asked, “Mr. Gottlieb, what is valuation?”

He didn’t ask me to explain the genesis of the fair market value standard or the premise of value used in my report.  He completely ignored the first set of questions we carefully planned.

My initial response was, “excuse me”.  He repeated the question, “What is valuation?”

Not to lose the attention of the Judge, I responded with confidence, “Valuation is the prophecy of the future”. With that, the usual and customary questions defining the general valuation theory and how one selects the most appropriate method for each instance quickly ensued. 

We were back on track, following the script that has been written many times before.

So, now that we are clear what valuation is, the next question – How is the future determined? – needs to be addressed.

The income approach is often used to determine the initial indication of value.  Simply stated, the income or cash flow of the business that is expected to continue in perpetuity is utilized.

In this week’s blog, we are providing our readers with a cram course comparing and contrasting the differences between the Discounted Cash Flow and Capitalization of Earnings Methods.

The Discounted Cash Flow Method.

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.” This method entails these basic steps:

Step 1 – Compute future cash flows.

The paramount questions investors ask is generally (a) what cash flow will the business generate? and (b) what would be the expected return on investment? Historical earnings are often the starting point for estimating expected cash flow over a discrete discounting period.  From a practical matter, we consider this to often be a five year period. Once determined, the terminal (or residual) value is calculated. 

Step 2 – Discount future cash flows to present value.

Once cash flows have been forecasted, it is adjusted 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, this amount must be reduced by the interest-bearing debt at the valuation date to arrive at the value of equity.

The Capitalization of Earnings Method.

The same valuation glossary defines capitalization of earnings/cash flow 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.

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:

Step 1 – Compute the expected cash flow for a single period.

Step 2 – Divide cash flow from the single period by a capitalization rate.

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, interest-bearing debt may need to deducted to arrive at the value of equity.

Which Way To Go?

So, which method is more appropriate?

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.

These two methods are exclusive of one another.  In other words, their results are never weighted together to form a single indication of value. 

Hopefully, this short comparison has provided some clarity.  If you have questions about this or any other valuation issues feel free to contact me at the above phone numbers.  I can also be reached via email at msgcpa@msgcpa.com

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