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 investors such as 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. We 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 market value, it means the company is undervalued.

We can calculate the equity value per share by divide it by the number of outstanding shares. And then compare it with the share price, so we will see the difference per share.