The capitalized cash flow valuation method is a great way to value an established company which is expected to have a consistent growth rate going forward. Clearly this valuation technique isn’t well suited to the many startups with negative cash flows and hopes of exceptional growth in the future.
However, it’s a good place to start when thinking about valuing a company. Startups have so many unknown variables that valuations are more art then science. It’s best to start of with a profitable company – what every startup aspires to be – to understand what drives value.
Like any valuation technique, determining the assumptions and inputs for the model will be the most difficult step. The math is relatively straight forward.
The basic formula for the capitalized cash flow approach is as follows:
Ev – Enterprise Value
Is the value of the entire company which can be broken down further for each class of investor. The most common types of investors in a company are the debt and equity holders.
DCF – Discretionary Cash Flow
Represents the cash generated by the business after all costs required to maintain the current cash flow are taken into account. You can learn more about discretionary cash flow and why it is very relevant for valuing a company here.
i – Interest on debt
Next we back out interest paid on debt to arrive at discretionary cash flows before any payments to investors in the company. This step is required since we are calculating the enterprise value which is the value of the company to all investors.
D – Discount Rate
The most widely accepted discount rate for valuing a company is the Weighted Average Cost of Capital (WACC). This is effectively the cost to the company to raise additional capital assuming that they maintain their current capital structure (debt to equity ratio). You can learn more about calculating the WACC here.
g – Growth Rate
This is the growth rate you expect the company to maintain indefinitely. You will need to use your own assumptions and analysis to arrive at the growth rate – a very important input for the model. You can read about ways to estimate the growth rate here.
Reasoning Behind the Method
At it’s core, this formula for the capitalized cash flow method is calculating the present value of a growing perpetuity. That is, the value, in today’s dollars, of receiving an amount of cash every year indefinitely which grows at a set rate each year. In our case, the “cash received” is the discretionary cash flow since it represents the cash which provides a return to investors.
Arriving at Equity Value
Once we have completed the above formula we are left with the enterprise value of the company – not the equity value which we are looking for. We need to take out the value of the debt investments in the company in order to arrive at our equity value.
Equity Value = Enterprise Value – Interest Bearing Debt
Lucky for us finding the value of debt is usually easier than finding the value of equity. This is because debt has predefined future cash flows. The only unknown with regards to debt is the risk of default. Note that special rights held by certain debt holders can add value to the shares and must be taken into consideration.