Capitalized Cash Flow Method
The capitalized Cash Flow Method is the valuation method used to value the private company which expects to grow at a certain rate. It is also known as the Earning Capitalization method. It will evaluate the company value base on the company’s expected earnings.
Capitalized cash flow will show the potential return from purchasing the company while presenting the risk at the same time. Investors really need both information to balance between risk and reward from their investments. However, this method is only suited for small private companies due to its limitation.
Free Cash Flow to the Firm (FCFF) is the cash available after paying the operation cost such as current assets, non-current assets, operating expenses, and tax. The company will be able to use this cash to pay for bondholders and shareholders. However, the company also has a choice to keep this cash for reinvesting as well. FCFF is also known as Discretionary Cash Flow.
WACC is the average cost of capital that a company pays to obtain the cash to finance its operational assets. It is the minimum return that the company needs to make.
The growth rate is the rate which we expect the company generates from year to year. It is the sustainable growth in cash inflow that the company will be able to make.
Capitalized Cash Flow Formula
In order to calculate Capitalized Cash Flow, we use the Free Cash Flow to Firm and divided by the WACC minus growth rate.
| \[Enterprise \ Value = {FCFF \over WACC-g}\] |
Capitalized Cash Flow Example
ABC is a private company with the following information below:
| Description | Amount |
| Expected FCFF | 10,000,000 |
| The growth rate in FCFF | 5% |
| The required rate of return | 8% |
| WACC | 15% |
Enterprise Value = $ 10,000,000/(15%-5%) = $ 100,000,000
Equity Value from Enterprise Value
By using above formula, we will be able to calculate the enterprise value of the company. We can use the enterprise value to calculate the equity value by deducting the debt value.
| Equity Value = Enterprise Value – Interest-Bearing Debt |
The company’s equity will allow the investor to compare with the market value. It will allow us to check if the company is overvalued or undervalued. If the equity is lower than the market value, it means that the company is overvalued. If the equity is higher than the market value, it means the company is undervalued.
We can calculate the equity value per share by dividing it by the number of outstanding shares. And then compare it with the share price, so we will see the difference per share.
How to value a company based on Capitalized Cash Flow?
There are many ways to value a company, but one common method is to base the valuation on the company’s Capitalized Cash Flow (CCF). The CCF is calculated by taking the company’s after-tax operating cash flow and dividing it by the capitalized rate. This number can then be used to estimate the value of the company’s equity. When valuing a company using the CCF method, it is important to keep in mind that the cash flows used in the calculation must be based on a realistic projection of the company’s future performance. Furthermore, the cost of capital must be carefully estimated in order to ensure that it accurately reflects the riskiness of the company’s business. When done correctly, valuing a company using CCF can provide a helpful indication of its true worth.
We can use the capitalized cash flow to value the company. There are several steps as follows:
- Calculate the sustainable earning: A sustainable earnings base is a key financial concept that companies use to determine how much they can pay out in dividends without impacting their long-term financial health. In order to calculate a sustainable earnings base, companies take into account a variety of factors, including future earnings growth, the company’s current debt load, and expected changes in the business environment. While there is no universally accepted formula for determining a sustainable earnings base, the concept is essential for ensuring that a company can continue to pay out dividends without putting its financial future at risk. By carefully evaluating all of the relevant factors, companies can ensure that they are making sound decisions that will help them meet their long-term financial goals.
- One of the most important aspects of effective financial planning is converting projected earnings into projected cash flows. This process requires a careful analysis of a company’s income statement in order to identify which items will need to be adjusted in order to obtain an accurate picture of future cash flows. Many times, items such as depreciation and amortization will need to be added back in, as they are non-cash expenses that will not affect the company’s actual cash position. Likewise, one-time items such as gains or losses on the sale of assets should be removed from the equation. By making these necessary adjustments, companies can get a much clearer picture of their future cash flows.
- When it comes to real estate investing, one of the most important things to understand is the capitalization rate. Simply put, this is the rate of return you can expect to earn on your investment. To calculate the capitalization rate, you simply divide the property’s net income by its purchase price. For example, if a property generates $10,000 in annual net income and it cost you $100,000 to purchase, your capitalization rate would be 10%.
Figuring out an appropriate capitalization rate can be tricky, as there are many factors to consider. For instance, properties with high vacancy rates or those in need of significant repairs will likely have a lower cap rate than well-maintained properties in desirable locations. It’s also important to remember that your personal goals and risk tolerance will play a role in determining what capitalization rate is right for you. Ultimately, it’s important to do your research and consult with a professional before making any decisions.
- The application of the chosen capitalization rate is a crucial step in order to calculating the value of the company. This rate is used to determine how much the company is worth and how much it can potentially grow in the future. It is important to choose a capitalization rate that is realistic and achievable in order to get an accurate valuation of the company. There are a number of factors that need to be considered when choosing a capitalization rate, such as the current market conditions, the company’s financial stability, and the industry average. Once the capitalization rate has been chosen, it can be applied to the company’s financial statements in order to calculate its value.
Example
| Account | Amount |
|---|---|
| Weight Average Normalized After-tax Net income | 2,000,000 |
| Adjustment cash flow to equity: | |
| Depreciation Expense | 50,000 |
| Capital Expenditure | (100,000) |
| Change in working capital | (120,000) |
| Distributable Cash Flow | 1,830,000 |
| L.T Growth Rate | 1.05 |
| 1,921,500 | |
| Divided by capitalization rate | 20% |
| Value company equity | 9,607,505 |