CEO Jason Kulpa compares capitalization of earnings vs. discounted cash flow in a business appraisal.
Before buying or selling a business, an appraisal to estimate the company’s worth must be conducted. There are two methods of assessing a company’s value: capitalization of earnings and discounted cash flow. Each method has benefits and drawbacks, as entrepreneur and CEO Jason Kulpa explains.
An Overview of the Methods
The capitalization of earnings method calculates the net present value (NPV) and divides it by the capitalization rate, also known as the cap rate. The second method, discounted cash flow (DCF), estimates the present value of a company based on the money it can generate in the future.
Capitalization of Earnings
The capitalization of earnings helps investors to understand the potential risks and rewards attached to a business. Historical earnings—usually the most recent five-year period—are used as the starting point for estimating future earnings. Once cash flows have been projected, they are adjusted to present value.
Benefits of the capitulation of earnings method include:
- Reliability for companies with an established cash flow
- Easily understood
- Assumes a slow, steady growth rate
Drawbacks to using the capitalization of earnings method include:
- Projected calculations can be inaccurate, resulting in values that are lower than expected
- Start-ups may lack the data necessary for accurate valuation
- Unexpected events can compromise earnings and affect the value
In essence, the capitalization of earnings model is favorable to established businesses with a long history of earnings.
Discounted Cash Flow
The DCF analysis is most useful when the financial analyst has confidence in a company’s future earnings. While it is a straightforward method that’s relatively easy to apply, the weaknesses in DCF require additional valuation tools for investors to make a sound decision.
Benefits of the discounted cash flow model include:
- Includes all major future projections about a business
- Can be used to evaluate the whole business or individual components of a company
- Determines intrinsic value
- Can be modified to deal with highly complex circumstances
- Suitable for analyzing acquisitions and mergers
- No comparables required
The main drawbacks of the DCF method are:
- Results can be overly complex
- A slight change in inputs can result in a significant change in valuation
- Relies on the future projection of cash flow, which can be difficult to predict
- Considers company value in isolation
- Does not consider the value of competitors
- High level of detail involved can lead to overconfidence
A knowledgeable financial analyst should be aware of the pros and cons of the DCF method. Discounted cash flow analysis is most accurate when used with other tools to create an accurate system of checks and balances to validate results.
Which is Best?
The valuation method you choose depends on many factors. The capitalization of earnings model is convenient when a business needs to be valued due to litigation or when it has a long history of earnings. However, DCV offers greater flexibility, especially when short-term fluctuations in growth are expected. Start-ups that aren’t yet profitable will certainly benefit from using the DCV method.
DCV and capitalization of earnings models are never used together to calculate a single measure of value. Though a financial analyst will offer advice on which valuation methods are best for a specific circumstance, it is crucial that the potential buyer understands how and why particular methods are used.
About the Author
Jason Kulpa is a serial entrepreneur and the Founder and CEO of UE.co, San Diego’s Fastest Growing Business, multi-year award winner. He is also a two-time winner of the Most Admired CEO Award of the San Diego Business. Under Mr. Kulpa’s leadership, in 2018, his teams volunteered at over 24 events and worked side-by-side to improve the San Diego community.