Valuation: Capitalized Earnings vs DCF

In business valuation, two methods stand out: Capitalized Earnings and Discounted Cash Flow (DCF). Which one should you choose for your appraisal projects? Each method brings its unique perspective to the table, offering you a different way to view the value of a company.

Capitalized Earnings: a snapshot of stability

Capitalized Earnings is a valuation method that places a significant emphasis on a company’s earnings. It simplifies the valuation process by converting future earnings into a present value. Importantly, the method uses a single earnings number to provide a snapshot of the company’s expected future income stream.

Valuing a business with this method involves dividing the expected annual earnings by the capitalization rate. The capitalization rate equals the discount rate minus the expected earnings growth rate. This method is particularly useful when valuing established companies with consistent earnings patterns.

However, the Capitalized Earnings method comes with its own set of limitations. It assumes a constant growth in a company’s earnings. As such, it may not be the best fit for businesses with volatile earnings or those experiencing rapid growth.

Discounted Cash Flow: peering into the future

In contrast, the Discounted Cash Flow (DCF) valuation method gives you a more precise way to value a company based on an expected earnings stream. DCF uses the company’s projected cash flows, discounting them back to their present value using a discount rate.

DCF takes into account the changes in future cash flows over the projection period to value the company. For a business whose earnings vary a lot over time DCF provides a more precise value result.

One of the advantages of DCF is its flexibility. It accommodates changes in growth rates and can be adapted to various business scenarios. However, the method requires that you create realistic cash flow forecasts for the company. In addition, you need to choose the discount rate carefully.

Choosing the right valuation method

Ultimately, the choice between Capitalized Earnings and Discounted Cash Flow depends on the nature of the business being valued and the appraiser’s preferences. Capitalized Earnings technique gives you a quick and straightforward snapshot of a company’s value, making it suitable for stable, established companies. On the other hand, DCF is a more detailed and adaptable method that works best for companies with uncertain and rapidly changing future cash flows.

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