Business Valuation Guide

Income-based business valuation

To capitalize or discount?

A quick look at business valuation under the income approach shows that you have two key types of methods available:

Given these two ways of doing the same thing you may wonder:

As the math below demonstrates, there are specific situations when these two types of business valuation methods produce identical results. Strictly speaking, the following is true:

If the business earnings are unchanged or grow at a constant rate year to year, then the capitalization and discounting business valuation methods are equivalent.

This offers some useful insights:

If business earnings vary significantly over time, your best bet is to rely on discounting when valuing a business. Since you can make accurate earnings projections only so far into the future, the typical procedure is this:

  1. Make your business earnings projections, e.g. 3–5 years into the future.
  2. Assume that at the end of this period business earnings will continue growing at a constant rate.
  3. Discount your projected business earnings.
  4. Capitalize the earnings beyond this point. This gives you the so-called residual or terminal business value.

The math

Take a look at the present value discount formula:

PV = (CF₀ (1 + g)) ÷ (1 + d) + (CF₀ (1 + g)²) ÷ (1 + d)² + (CF₀ (1 + g)³) ÷ (1 + d)³ + ⋯

Where CF0 is the business cash flow as of the business valuation date, g is the constant annual growth rate in the cash flow, and d is the discount rate.

Now compare the above with the well-known result for the sum of the so-called geometric series:

1 ÷ (1 − q) = 1 + q + q² + q³ + ⋯

Note that the present value is just the geometric series less the first term, which is equal to 1. Now make this substitution:

q = (1 + g) ÷ (1 + d)

Which gives us the famous constant growth capitalization formula:

PV = (CF₀ (1 − g)) ÷ (d − g)