Definition:

Company valuation tends to be one of the most important calculations for any company, simply because of the reason that it defines how much they are worth in the market.

It tends to be a highly important metric for investors, and other various stakeholders, because they are able to get an idea if their investment in the company is going to render positive returns for them in the near future.

Despite the fact that there are numerous different methods for company valuations, yet it can be seen that capitalized cash flow is one of the most commonly used methods of valuation.

Capitalized Cash Flow method can be described as a method that is used to value companies, depending on the cash flows of the company. This method mainly involves a single economic benefit being capitalized at the capitalization ratio, which subsequently provides the firms valuation at a certain date.

Here, the capitalization rate is defined as the spread between the required rate of return and the company’s expected growth rate.  

This particular method to valuate companies is used when the company is expected to have relatively stabilized level of margins (and hence, cash flows), as well as growth in the future.

This particular method is described as an income-based approach to value companies, and it contingent on the projection that the company will have similar streams of income in the coming future.

Therefore, it can be seen that this particular method involves valuing business based on the existing cash flow stream that is subsequently capitalized by the risk-adjusted return.

Related article  What should be included in cash flow from financing activities?

Formula:

The underlying premise in the Capitalized Cash Flow method is the fact that the company is perceived to be a growing perpetuity. The assumption here is the fact that the company will continue to grow at a constant rate.

Therefore, this particular approach is only valid for companies and organizations where the company is expected to grow at a constant rate.

In order to calculate the value of the company using Capitalized Cash Flow Model, the following formula is used:

Value of the company = (Expected Free Cash Flow of the Firm) / (WACC– expected growth rate)

The above formula is used in the case where Free Cash Flow is given, along with weighted average cost of capital for the company.

However, in the case where valuation is to be derived using Free Cash Flow to Equity, the formula changes. In that case, Free Cash Flow to Equity is divided by the spread between the required return of equity and the expected growth rate of the company.

Therefore, in this case, the following formula is used for calculating the value of the company:

Value of the company = (Free Cash Flow to Equity) / (Required Rate of Return on Equity – Expected growth rate of the company).

How to Value a Company Based on Capitalized Cash Flow Method?

The main steps taken when valuing a company using Capitalized Cash Flow Method are as follows:

  • Determination of a sustainable earnings base
  • Making necessary adjustments in order to convert projected earnings into projected cash flows (this also requires making adjustments for capital expenditures, depreciation, and changes in the working capital as well as other debt instruments.)
  • Figuring out a suitable capitalization rate
  • Application of the chosen capitalization rate in order to calculate the value of the company
Related article  How do depreciation expenses present in Statement of cash flow?

The steps that are mentioned above are necessary in order to correctly evaluate the free cash flow, and then subsequently arriving at the valuation of the company.

Non-cash expenditures (like depreciation) need to be adjusted in order to arrive at a free and fair value of free cash flow. In the same manner, it is also important to have proper clarity about the growth rate of the company.

Example of Valuation using the Capitalized Cash Flow Method

In order to illustrate the steps mentioned above, the following illustration is provided:

Particulars Amounts
Net Income 1,000,000
Adjustments to the Net Income  
Capital Expenditure(185000) 
Changes in Working Capital(150000) 
Depreciation50000 
Changes in Debt(15000)(300000)
Estimated Cash Flow 700000
Projected Cash Flow Growth3% 
Projected Cash Flow 721000
   
Required Rate of Return13% 
Growth Rate3% 
   
Capitalization Rate 10%
   
Value of Company’s Equity 7,210,000
   

Therefore, as per the example mentioned above, it can be seen that the value of the company’s equity, according to the Capitalized Cash Flow Method turns out to be $ 7,210,000.

In the process above, it can be seen that certain adjustments are made to the net income. This is because the premise of this particular method lies in using income, and then making adjustments to it in order to arrive at the value of the company’s equity.