How does the capitalized cash flow method value a business?

The capitalized cash flow method is one of the methods inside the income approach. It asks for two inputs: a single representative period of expected cash flow, and a divisor called the capitalization rate. This page explains what each input is, using the definitions of CBV Institute and BDC. It gives no rate and no example figures; ask a qualified valuator how a rate was chosen for a particular business.

The cash flow input

The glossary defines the capitalization of economic income method as converting expected economic income for a representative single period into value through division by a capitalization rate. It also lists the capitalization of earnings method as a form of that method. It defines cash flow as inflows or outflows generated over a period, often with a qualifier such as discretionary or operating. The glossary defines normalizing adjustments as adjustments to the financial statements for nonoperating assets and liabilities, and/or for extraordinary, nonrecurring, noneconomic or other unusual items. Ask which cash flow was used and what was adjusted.

The capitalization rate

The glossary defines a capitalization rate as a divisor used to convert the expected economic income of a normalized single period into value, and says it is generally calculated as a discount rate less a long-term growth rate. The CRA’s Information Circular 89-3, which sets out how the CRA generally values closely-held corporations for income tax purposes, says risk, expressed in a going concern value calculation as the capitalization rate, relates to a number of factors in the business, among which may be the tangible asset backing, the liquidation value, the nature and history of the operations, specific industry and market comparisons, the financial condition of the business, the quality of its operations, the stability or irregularity of its maintainable earnings or cash flows, and the choice of and rates of return on alternate investments. The circular adds that the list is not exhaustive and that the valuator must exercise judgment on which factors are relevant.

When BDC points to it

BDC lists capitalized cash flow among earnings-based approaches and says it is used when cash flow is expected to remain stable in future years. BDC says earnings-based approaches are commonly used for businesses that generate reasonable profits and whose value is greater than that of their net assets alone, and quotes a chartered business valuator who says historic results provide guidance but are not necessarily indicative of future results. For the wider family, see the income approach.