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.More on Valuation