Archive for the 'Business Valuation Tips' Category

Figuring out the actual values of business assets is a common task in business appraisals. Pick up the property records in a typical company, and you are looking at the book values.

Welcome to the real world. The fact is that business assets can and do disappear, while being on the books. On the other hand, some valuable assets can be in use while not on the books at all.

Don’t expect that this difference comes out in the wash. Your accountant may want to offset such imbalances, but two wrongs don’t make it right. How do business assets wind up on the company’s books? Usually, your accountant keeps records of business assets using their original cost of purchase less depreciation.

What this book value does not represent is the true fair market value (FMV) of the asset. To make matters even more interesting, the fair market value can be estimated on the premise of the asset in use or in exchange. The first assumption is that the asset will continue being used in business operations. The second is that the asset will be offered for sale. The value may differ by quite a bit.

The key point is that the price you paid for a piece of equipment or software application years ago may bear no resemblance to what the asset is worth today. Technological obsolescence has really changed the game in asset valuation. Just because a custom software cost you, say, $100,000 in 2000 does not mean its value is anywhere near that today.

Purchase price allocation calls for business asset valuation

Even so, there are examples in business appraisals when current fair market values of some business assets are close to their book values. This is more likely to be the case if you are valuing the entire company and the assets are expected to be in use. If the business is offered for sale, purchase price allocation across the assets is one scenario when accurate asset valuation is needed.

Market value of business assets – another perspective

If the company plans to divest of some of its assets, you may find that the market place has a very different idea of what these assets are worth. This comes up when business assets are viewed as a collateral against a bank loan. Your lender is not interested in using the assets. Instead, the likely selling price in the event your company defaults is important.

Liquidation value – when assets are sold at an auction

The appraisers call this the liquidation value. It is established at an auction attended by the equipment brokers or other companies looking to get usable assets at a discount. You can bet on the selling prices being lower than the book value in these situations.

Does the value of a company depend on which country it operates in? The answer is yes, and here is why.

Business value is about risk and return. In other words, what makes a business valuable is how much money it makes given an acceptable level of risk. Investors, including business owners, look to put their money into business ventures that promise reasonable returns, both on their money and of their original investment.

Why business values differ by country

When sizing up business risk, the country’s economic and political conditions matter. Consider operating a company in a well run, developed economy such as Western Europe or North America. Political situation and the laws governing commerce are well understood and enforced. Financial markets are highly efficient and liquid. If you invest in a public company, you can unload your holdings in a few moments and move your money into a different investment.

The situation in less developed or politically troubled countries may be very different. The rule of law may be confusing or hard to discern. Exporting your money may well be fraught with difficulties or be very expensive. Bribes and protection rackets could plague the unwary investors. Your erstwhile business partners could turn out to be plain crooks.

Global financial markets abhor such instability. If the investors as a whole see systemic problems in a given country, they usually vote with their feet and take their investments to safer havens.

If you are adventurous, you may give investment in an emerging economy a shot. After all, risk and reward go together.

Unsurprisingly, the global investment community has a way to assess just how risky a business investment is in a given country. Consider how the discount rate for business valuation is built up. This discount rate captures the risk of your business investment. Note the equity risk premium, or ERP for short, in the equation.

Equity risk premium and country risk premium

For advanced, stable economies such as the USA or Western Europe, the ERP is measured by the returns on a major equities index, such as Standard and Poor 500 (S & P 500). The countries rated by the major credit agencies at the top of the scale get the Aaa rating. What this means is that investing in such countries is about as good a bet as investing in the broad portfolio of companies covered by the S & P 500 index.

Put differently, business investment in the USA, Canada, or Germany is no more risky than the equities market as a whole. Such advanced economies do not have any additional risk premium by country.

However, business values in less developed or stable countries is more risky. If you choose to invest in a company in many South American or Middle Eastern countries, your investment carries an additional country risk premium. How high the premium is depends on the risk spread of the particular country.

Example: business values in advanced vs developing countries

How does this country risk premium affect business values? Lets take an example of two companies, each generating $300,000 in net cash flows and growing at an annual rate of 5.47%. Both companies are debt free, so their cost of capital is just the equity discount or cap rate.

Let’s further assume that both companies are small, under $50M in market capitalization, and offer professional engineering services. The first company, based in the USA, has the equity discount rate made up of these parts:

Risk Element Risk Value, %
Risk free rate (based on US 10 year Treasury yields) 2.5%
Equity risk premium 5.7%
Country risk premium 0%
Small company size premium 11.59%
Industry risk premium 0.46%
Company specific risk premium (CSRP) 4.1%
Equity Discount Rate 24.35%

This gives the total equity discount rate of 24.35% and capitalization rate (cap rate) of 18.89%.

The second company in our example is based in Argentina, the country rated B3 by Moody’s. The country risk premium is around 9.3%, which gives us the total discount rate of 33.65% and cap rate of 28.19%.

Difference in business valuation by country

We next use the constant growth direct capitalization business valuation method to figure out what each company is worth. Remember, the only difference in this scenario is the country risk premium. Here are the results:

Business value of the US-based company

Business value: $1,675,230

Business value of the Argentina-based company

Business value: $1,122,506

As you can see, the difference in business value is considerable. Given a choice, any rational investor would go for the US company due to its lower risk. The Argentina based company would have to throw off more cash increasing its returns in order to compensate the investors for its higher risk.

Whether you are buying or selling a private business, establishing its market value is critical to a successful transaction. Depending on which side of the transaction you are, you may need business valuation for these reasons:

  • Determine a reasonable selling price
  • Support your asking price
  • Screen businesses for sale to select promising acquisition targets
  • As a reality check in a business acquisition negotiation

Finding the right business selling price

In the minds of business owners, the best selling price is what meets their personal or business goals. It may be a retirement package or cash needed to get into a new venture.

The point to remember is the actual value of a business has nothing to do with the owners’ goals. It is an economic concept that rests on the business financial and operational outlook. Even historic performance is of little value except as a guide for estimation of the business future prospects.

If your business valuation disappoints, there is work to be done before the business goes on the market. You would need to review the key business value drivers and see what you can do to increase the valuation in order to meet your exit strategy objectives.

Increasing business earnings, putting a professional management team in place, or reducing key customer concentration can all go a long way toward increasing your business worth as well as making the company a more desirable acquisition target.

Is the asking price right?

No other piece of the business for sale puzzle causes more contention than the asking price. Sellers want the highest price possible, while buyers look to get the business on the cheap.

In a business sale, a reasonable price and terms will make or break a deal. A solid business valuation is your ticket to getting the negotiation off on the right foot. A business selling price that is backed by careful analysis is far more likely to lead to a successful deal.

Screening business for sale targets

One way to avoid the frustration of endless haggling is to screen business for sale listings. Doing this quickly and efficiently is the sure way to avoid fruitless debates with the sellers who refuse to budge. You can run quick valuation calculations, comparing the target companies to the actual selling prices, or estimating the multiple of discretionary earnings the seller expects.

If the target looks overpriced, consider moving on to more attractive opportunities.

Price justification – the reality check of business selling price

If you ever saw a business offering memo prepared by a good business broker, the suggested price and terms are usually included. The question is whether the deal matches the needs of both the buyer and the seller.

Such deal checks are important as they let both parties know what terms are acceptable. Regardless of the business valuation result, a business sale must address the needs of the actual buyer and seller. No two buyers have the same expectation of return on their investment, the same skill set or ability to recruit key employees. In addition, financial strength of the buyer can make a lot of difference as to the amount of down payment or ability to raise a loan to fund the business sale.

If you are considering a dental practice appraisal, here are some interesting industry statistics:

There are over 133,000 privately owned dental practices in the US alone, classified under the SIC 8021 and NAICS 6212. Dental practices are a large part of health services and generate around $104B in annual revenues growing annually at 11.6%. 

Yet an average dental practice is a small service business – employing a staff of 6 – 7 and producing some $787,000 in annual sales. Revenue per employee is about $119,000. Dental practices employ some 882,700 staff.

Dental practice valuation methods – comparable practice sales

Practice sales happen regularly so there are plenty of comparable data to use for valuing a dental practice. There are a number of valuation multiples to choose from, each giving you a different way to determine the practice value. Here are the top ones most often used to price a dental practice for sale:

Surprised by this list? Well, the traditional way to assess a dental practice value has relied upon the net sales or gross annual revenues. However, the market for dental practices is quite dynamic and pricing trends change over time.

We keep an eye on the spread of actual practice selling prices from the average. This is handily captured by the coefficient of variation – the smaller this number the tighter the selling prices cluster around the mean. If you want to estimate your practice value, use the valuation multiples with the smallest coefficient of variation first. This means that practice buyers out in the market rely on these multiples more often when pricing acquisitions.

Recent dental practice sales data show that the gross profit based valuation multiples can give you the most accurate estimate of current practice value. In fact, its coefficient of variation is just 0.39 compared to 2.39 for the net sales based multiple.

Example: How to price a dental practice using multiples

Consider an average private dental practice generating $300,000 in annual net sales, having a gross profit of $275,000; discretionary cash flow of $100,000; and market value of all invested capital, which includes the practice assets and long-term liabilities, of $85,000.

Let’s take reasonable values of the respective valuation multiples for use in our value calculations:

  • Sale price to gross profit: 0.7.
  • Sale price to total invested capital: 2.
  • Sale price to net sales: 0.6.
  • Sale price to discretionary cash flow: 1.7.

Applying these valuation multiples gives us the following practice value estimates:

  • Based on gross profit: $192,500.
  • Based on total invested capital: $170,000.
  • Based on net sales: $180,000.
  • Based on discretionary cash flow: $170,000.

This gives us the average practice value of $178,125.

By convention of professional practice appraisals, the value includes all tangible assets and practice goodwill. It does not include cash, accounts receivable, liabilities or real estate. The value of earnouts set aside as a contingent part of the selling price, if present, is also excluded.

Dental Practice Valuation Multiples

Recent sales of private dental practices are an excellent source for estimating your practice value. See how to value a dental practice based on its gross revenues, net sales, profits, EBITDA, cash flow and assets.

See Example »

Other methods for dental practice valuation

As in other health care practice valuations, the value of a dental practice is driven by its earning capacity. You can use a number of income based valuation methods to determine what your practice is worth. Both Multiple of Discretionary Earnings and Discounted Cash Flow methods are frequent choices in dental practice appraisals.

For an established practice, consider using the Capitalized Excess Earnings method that lets you estimate the value of practice goodwill. This may well make up a large part of the overall practice value.

In the real world comparisons rule. We compare products, services, features and prices all the time. Price per square foot is the yard stick used by the real estate industry to compare properties. In a world of substitutes it seems there is always the next best thing out there.

But how about this: can you compare a one of a kind painting by a famed artist to somebody else’s work? Probably not. Reason is simple: a work of art is not the same as another. There are no substitutes for the real thing.

In business valuation, the situation may be quite complex as well. While many companies can be compared to their industry peers, some businesses are unique enough to defy comparison.

Imagine, for example, comparing Google to figure out its value in the early 2000’s before the company went public. There were no other businesses who offered the kind of search engine technology Google became famous for. If you tried to use market comparisons, you’d be matching the proverbial apples and oranges.

Indeed, professional appraisers know that market based comparisons may be misleading. After all, each business is unique. It is precisely its specific value set of drivers that determine its true value. Things like technology, business relations, skills of the company’s staff, and relationship with its customers tend to play a significant role in how it competes. No two businesses are ever the same.

Yet market comparison is based on the simple assumption that businesses operating in the same industry are interchangeable. If you know the selling price of several companies out there, you can estimate the value of your firm. Well, yes and no.

Market comps are good for initial business value estimates. It is easy to see how valuation multiples you get from sold businesses can be applied to your company’s revenue, asset base, EBITDA or net income to figure out what your company may be worth.

Market evidence is also useful if your business valuation comes under fire. Examples are legal disputes, or challenges by the tax authorities. If you can furnish proof of companies’ selling prices, your business value analysis gains support from the actual market place.

However, as the saying goes, there are lies, damn lies, and statistics. Market valuation is based on statistics collected either by yourself or someone else. The stats may be very misleading, depending on who and how collects and analyzes the market data.

Private business sales data is a case in point. Usually, such data is collected on a voluntary basis by business brokers. Only a fraction of the actual business sales ever get disclosed to the business sale data vendors.

Business people and brokers are not required to report private company sales to anyone. Most of such sales never get reported. Business owners may consider their acquisition strategy highly competitive. Brokers may view their knowledge of the market place as a key advantage and keep their deal statistics to themselves. What you see is just a sliver of the actual deal flow.

In addition, most business brokers are not financial reporting experts. Be wary of the financial numbers as they are not reviewed, let alone audited by a financial accounting professional. That is one reason private business financials require adjustment or normalization before you can value a company.

For these reasons, many business appraisal experts tend to approach the market valuation methods with caution. One way to get better quality data is to examine small cap public companies or private company acquisition deals done by public firms. Such transactions must be reported to the authorities, such as the US Securities and Exchange Commission, under law. In addition, the financial numbers must comply with the standard GAAP format and be audited by licensed accountants.

So your comparison is more likely to be “apples to apples”. But what about the difference between the public and private companies? Business appraisers use the discount for lack of marketability to adjust the valuation multiples from public company sources. Fortunately for your business valuation, the difference is visible in the market place – just check the prices of restricted company stock and freely marketable shares of the same firm. This measure of price reduction gives you an idea how much the investors discount the value of assets that have limited marketability.

Remember that market comparison is but one approach to business value. To uncover what your company is really worth, you need to apply the various methods under the income and asset approaches. In particular, the income valuation helps you delve into the value drivers that create business value. This type of analysis is as unique as the company itself.

Ask any professional business appraiser and you will get an earful about the financial statements, adjustments and the true economic income estimation. Why all the fuss?

In a perfect world, you should be able to figure out business value by just using the company’s financial statements. After all, don’t the income statements and balance sheet capture the company’s financial performance? It turns out, not quite.

If you are not a seasoned accountant, here is a quick rundown on how financial numbers are reported for businesses. In the US, the Securities and Exchange Commission (SEC) requires that all public companies prepare and file financial statements in accordance with the so-called generally acceptable accounting principles, known as GAAP.

Trouble is, there is no one place you can go to in order to understand what GAAP is all about. So accountants have developed a de-facto understanding of GAAP that they all follow. Even though the Financial Accounting Standards Board (FASB) sets the rules, it is the practicing CPAs that interpret GAAP and file the financials with the SEC.

Now, the foundation of GAAP is known as historical cost. One key point for business valuation is that only the assets the company paid for are recorded on the books. CPAs can then trace all such recorded assets to the original purchase invoice. The system functions quite well as long as the assets are in tangible form such as the real property, machinery, office equipment and furniture. If it comes to an audit, you can find the actual physical assets and trace them all the way back to the original purchase invoice.

GAAP misses the value of intangible assets

So far, so good. If the prices of assets change slowly over time, and inflation is kept under control, the system works well. But what if your company is rich in intangible assets such as intellectual property? The patented software developed by the internal R & D may be the most valuable asset your company owns. Yet, it is not a tangible asset purchased from a vendor. So there is no real book record for it!

What do you think is more valuable from a company investor’s perspective? Office furniture or highly prized software design that generates sales?

In many companies today, the value of such intellectual property far exceeds the value of all the tangible assets combined.

GAAP cost basis misses the market value

Clearly, GAAP financial reporting misses a key point when it comes to business value. The standard was developed in an industrial age when dealing with intangible assets was not an issue. Under GAAP the best you can do is capitalize the cost incurred in developing your patented technology, but not its market value!

Financials are normalized for business appraisal

Correcting this picture in order to determine the company’s true market value is the job for business appraisers. One method that stands out is the asset accumulation technique. You start with the company’s cost basis balance sheet and normalize it by adding the values of assets and liabilities that are missing. The result is an economic balance sheet, one that captures the market values of all assets, whether they have an accounting cost basis or not.

GAAP serves the needs of CPAs who are conservative by nature. As long as the system allows the accountants to do their job well, they are happy. But when it comes to business appraisal, you need to make adjustments that reveal the true value of the company.

What type of business earnings do you use in private business valuation? The difference could be huge, the results misleading.

Public or private, business value is about returns at a level of risk you can accept. Risk is typically captured in the form of discount or capitalization rates. You can calculate these by using the well-known CAPM or Build-up models. But before you can run your business valuation calculations, the business earnings need to be estimated.

If you pick the discounted cash flow method, the earnings need to be forecast over some future time period, usually several years. Capitalization calls for just one earnings number that should represent the company’s earnings outlook.

Are accounting multiples good enough?

But what type of earnings should you choose in your calculations? The choices are many and confusing. If you look at typical market based valuations for public companies, valuation multiples based on the accounting metrics abound. Price to EBIT, EBITDA, net income, gross revenues or net sales are common.

Private business valuations: Addbacks, normalizations

Yet in private business valuations the typical choices are the Net Cash Flow, abbreviated NCF, and Seller’s Discretionary Earnings or SDE.

Business appraisers talk about the process of financial statement reconstruction or normalization to get at these numbers. Business brokers refer to addbacks.

The reason is that privately owned companies do not need to comply with financial reporting standards, like GAAP or IFRS, unlike the public firms. So one company’s EBITDA may very well be different from another business.

Public firms maximize earnings; private firms minimize taxable income

Creative financial management aside, private businesses pursue very different financial goals from their publicly traded counterparts. While a public company strives to maximize its stock price, and, therefore, earnings per share; the private business owners are mainly concerned with minimizing taxable income.

Private companies don’t pay taxes – the owners do

Private businesses are generally organized as the so-called pass through entities, such as the S-corporations or LLCs in the USA. The companies do not pay taxes, the owners do as individuals. This also helps minimize business taxes as the owners may have additional expenses they can offset against business income to reduce taxes.

Public firms do this by moving operations into tax advantaged geographies, or getting major tax breaks from local governments in return for sizable investments in their communities. If you are a typical small business owner, this is not the game you can play.

Aggressive depreciation skews the earnings for private businesses

A private business has the additional benefit of accelerating asset depreciation. This allows business owners to recover costs quickly. However, it skews the actual asset use and reinvestment picture. Your EBITDA may be affected by such ‘paper expenses’, the D and A in this acronym.

In contrast, public companies are under constant scrutiny by the government. They must clearly demonstrate how they use the invested capital in order to inform their investors properly. The result is typically a much more realistic picture of asset depreciation.

Friends and family borrowing is not commercial terms

Interest expense is also tricky. Private companies may borrow from family members, friends, or business owners themselves on the terms not available in the public market. Public companies borrow money from commercial lenders. Invariably, the terms of such loans represent the current market conditions.

When you compare publicly traded companies, you can review their financial statements that have been prepared by professional accountants, subjected to an audit, and are in compliance with the GAAP (Generally acceptable accounting principles). This is generally not the case for privately owned firms.

Moral: Use Net Cash Flow and Seller’s Discretionary Earnings

As a result, accounting measures of income such as EBITDA or EBIT are not suitable in private business valuations. The business earnings need to be normalized in order to reveal the company’s actual economic potential. The normalization process enables you to establish the company’s earning power. Given your risk assessment, you now have all the inputs required to conduct an accurate and realistic business appraisal.

If you ever valued a private company, you probably ran across the venerable Multiple of Discretionary Earnings business valuation method. This technique is perhaps the most common in valuing owner-operator managed businesses. Its appeal is simplicity and excellent coverage of value factors that demonstrate what creates business value and how you can improve operations in order to increase business worth.

As this example shows, the Multiple of Discretionary Earnings method lets you assess the company across a set of key financial and operational performance factors. You score the business on each factor, input a set of financial figures, and the method calculates both the earnings multiple and the overall business value.

Better run, more profitable businesses generally command higher selling prices in the market. The Multiple of Discretionary Earnings method captures this trend very well. For example, you may ask the questions:

  • How much is business value affected by the stability of business earnings over time?
  • Is the quality of management team important to business value?
  • What is the effect of customer concentration on the company’s valuation?
  • Is a business with efficient, well documented business practices more valuable?

The method lets you answer all these questions and more. Importantly, you can spot weaknesses and opportunities to see how much your business value would increase if you made improvements. A great way to make strategic decisions that translate into a greater business value!

But one question remains. Just how high do the earnings multiples get in the ‘real world’? Is there a reasonable range of Seller’s Discretionary Earnings multiples a private business can actually sell for?

This brings us to the area of statistical data analysis. One way you can answer this important question is by studying comparable business sales. You can relate the actual business selling prices to earnings and calculate the earnings multiples observed in the market place.

Conventional wisdom tells us that private businesses tend to sell for somewhere between 0.1 and 4 times the SDE (Seller’s Discretionary Earnings). However, if you analyze the business sales data, you will discover that the range is quite a bit wider.

True enough, close to 90% of private businesses do sell for earnings multiples in the range of 0.1 to 4. But the upper 10% defy this trend.

Indeed, the top 10% of private businesses can price above 50 times the SDE. If you visualize the earnings multiple trend versus the percentile of sold businesses, the graph starts out smoothly, reaching the multiple of 4 for a 90% business sale percentile. Thereafter, the graph trends sharply up, reaching beyond 50 times the SDE for the top 1% of all businesses sold.

This is perhaps an interesting demonstration of the 10% – 90% statistical adage. The highest 90% of the earnings multiples are commanded by the top 10% of all businesses.

What are the reasons for such dramatic differences in selling multiples? Here are some we have noted:

  • Successful businesses at the top of their game command much higher valuation multiples than their peers.
  • The best businesses attract the bulk of business buyers and investors who bid up the selling prices competitively.
  • The top performing companies have the best earnings growth prospects, which directly affect their value.

One statistical reason often overlooked is that in some industries business sales are priced on other measures of financial performance or condition. For example, high technology companies are often acquired based on their assets, especially intellectual property; or their gross revenues.

The earnings multiples could be very high if these companies have not yet been optimized for peak profitability. The acquiring entity, typically a large corporation, may have a very different vision for profitability using its own economies of scale, market access, and capital to grow the young company further.

As you probably know, the Internal Revenue Service is the tax arm of the US Treasury Department. Unsurprisingly, valuation of businesses and other assets is of interest to the IRS. Through the years, the service has published a number of interpretations that have come to be widely supported in professional business appraisals.

These revenue rules, as they are called, do not have the force of law, representing instead the position the IRS takes toward business valuation best practices. As an example, regulatory guidelines may be used in the context of gift and estate tax laws that require appraisers to use specific valuation approaches or methods when valuing privately owned companies.

Some of the IRS publications are merely pronouncements with administrative authority. Again, they do not have the binding force of the law. Examples of these are the revenue rulings, private letter rulings, technical advice and general counsel memorandums.

As time went by, many of these publications were tested by courts in legal disputes. The case law that emerged lent support to some, but not all, IRS pronouncements. Some of the best known and supported IRS publications that stood the test of time are these:

Revenue Ruling 59-60

This publication is perhaps the best known IRS statement on valuation of private company ownership interests.

68-609

Deals with the fair market valuation of business intangible assets, including goodwill. The exposition of the so-called formula method is part of this paper.

65-193

Updates the Revenue Ruling 59-60 with specifics on intangible asset valuation.

77-287

Introduces the concept of lack of marketability and the restricted stock studies as a method to calculate the discounts for lack of marketability. If you are valuing a privately owned company whose stock is less marketable that shares of public companies, this is a very important point to consider.

93-12

Provides exposition of discounts for lack of control when valuing partial ownership interests in private companies. If you need to figure out the value of a partner’s share of business, the importance of control in business value estimation is something you should review carefully.

The private letter rulings (PLRs) and technical advice memorandums (TAMs) are the usual way the IRS responds to specific taxpayer inquiries. They are widely used for gift and estate tax valuations.

In general, you will find that many professional business valuations in the USA cite the IRS revenue rulings and other publications to enhance the credibility of appraisal. Remember, however, that the IRS guidelines are less compelling when valuation is done for non-tax purposes such as business sale situations.

If you are considering using the income based methods in your business valuation, you have two main choices: capitalization or discounting. In simple terms, the difference boils down to how you intend to treat the expected changes in business earnings going forward.

In using the discounted cash flow method, you specify the anticipated earnings explicitly in the calculation. On the other hand, the capitalization valuation implies that the business earnings will change at a constant rate in the future. This assumption is rarely met in the real world.

Capitalization also misses the timing of earnings changes. If your target company is likely to experience a rapid growth in earnings, especially early on, it’s best to use the discounting technique to capture it in your valuation.

On a general note, consider some situations that favor one choice of the valuation method over the other:

Steady, evenly growing earnings

If the rate at which the business earnings change is nearly constant then the capitalization of earnings is appropriate for valuation. The accuracy of your results likely would not improve if you used the more complex discounted cash flow technique.

Uneven change in business earnings expected

If you can generate a reliable earnings forecast with significant swings in the cash flow over the years, discounting will produce a more accurate result.

Significant change in earnings, uncertain timing

If your company’s cash flow is expected to change widely and timing of these changes is hard to predict, business risk is increased. The result is a higher discount rate. But since your earnings forecast is less reliable, the capitalization method is just as accurate in this situation.

Rapid business earnings growth over a short period

If your target company is experiencing a growth spurt that you can clearly forecast, use the discounted cash flow method. Once the company’s earnings settle into a more sustainable growth mode, you can make the assumption of constant growth rate in perpetuity. This is a perfect scenario for using the discounted cash flow valuation.

Want to dig deeper into the differences? Check out the capitalization versus discounting math.