August 2021
Under the income approach to valuing a business, a valuator must often choose between capitalizing earnings/cash flow and using a projection of earnings/cash flow. Deriving a value through capitalization involves dividing the base earnings/cash flow by a capitalization rate. The capitalization rate consists of the discount rate reduced by the long-term growth rate. Deriving a value by a projection involves projecting earnings/cash flow for specific years (typically one to five years), capitalizing the earnings/cash flow at the end of the projection period and discounting the earnings/cash flow and the capitalized value at the end of the projection period to present value. Mathematically the choice between the two methodologies it isn’t one or the other as if either is utilized correctly they will conclude the same value. However, in real life it is preferable to use one or the other based on the circumstances.
It should be noted that a capitalization of earnings/cash flow is really just a shortcut discounting to present value of a projection of the earnings/cash flow. The only difference is that a projection estimates earnings/cash flow for specific periods, typically in years, while the capitalization assumes that the earnings/cash flow will have constant growth, or the resulting value will equate to constant growth.
When a business is expected to have fluctuating earnings/cash flow that can accurately be estimated, the valuator will lean toward utilizing a projection rather than a capitalization rate. When earnings/cash flow are more speculative, the valuator will lean toward a capitalization of earnings/cash flow, as a projection may give the false impression of greater accuracy.
Projections are more often used in the valuation of large companies, where earnings/cash flow is more predictable, while capitalization is more often used in valuing small companies where earnings/cash flow typically has greater fluctuations.
If Management provides projections, either made for a different purpose or for the subject valuation, they should be scrutinized for reasonableness. Some projections are conservative, some are aspirational or best case scenario and some are improbable. In many cases, Management doesn’t or won’t prepare projections due to unpredictable historical earnings/cash flow. Many times we’ve heard clients say that they can’t predict next month’s earnings/cash flow, much less next year’s. In these cases, a capitalization would likely be more appropriate.
In summary, a capitalization method to valuing a business is more appropriate when projecting earnings/cash flow for specific years is difficult or projections provided by Management aren’t reasonable. Projections are typically more applicable when valuing large companies and capitalizations are more appropriate for small companies. However, the correct value of a business can be obtained in any case via either methodology.
Relevant Court Cases
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Kakollu v. Vadlamudi,
(Ind. App. 2021),
filed July 26, 2021
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Cela v. Cela,
Court of Appeals of Tennessee,
No. M2019-01861-COA-R3-CV,
filed July 30, 2021
Recent Business Valuation Articles
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“Organizational capital, corporate tax
avoidance, and firm value,”
by Mostafa Monzur Hasan, Gerald J. Lobo and Buhui Qiu,
dated July 21, 2021
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“How do ESG incidents affect firm value?”
by Francois Derrien, Philipp Kruger, Augustin Landier and Tianhao Yao,
dated August 11, 2021
Recent Engagements
- Valuation of 100% of the common stock of a niche manufacturing
company on a controlling interest basis for marital dissolution purposes.
- Valuation of the common stock of an investment holding company
and an equipment leasing company on a minority interest
basis for estate tax reporting purposes.
- Valuation of 100% of an investment services firm
on a controlling interest basis for gift tax
reporting purposes.
- Valuations of limited partnership interests
of investment holding partnerships on a minority
interest basis for gift tax reporting purposes.
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