Two techniques fall under the income approach umbrella when valuing a private business interest: the discounted cash flow (DCF) method and the capitalization of earnings method. How do these two commonly used methods compare — and which one is appropriate for a specific investment?

Fundamentals of discounting

The DCF method estimates the present value of future expected net cash flows using a discount rate. It 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.

Basics of capitalization

Under the capitalization of earnings method, economic benefits (typically, cash flows) for a representative single period are converted to value using a capitalization rate. This sounds similar to the DCF method, but it’s simpler.

This method requires just two steps:

• Compute expected cash flow for a single period.
• Divide cash flow from the single period by a capitalization rate.

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. It’s 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.

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 expert may also need to subtract interest-bearing debt to arrive at the value of equity.

The big decision

In general, the DCF method provides greater flexibility if management expects short-term fluctuations in revenue, 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 complicated DCF model. However, the DCF method is widely accepted in more sophisticated courts, such as the U.S. Tax Court or federal courts.

(This is Blog Post #1346)