A single-period valuation of an illustrative debt-free company, built from EBITDA to cash flow and from the build-up rate to the cap rate.
The capitalization of earnings method values a business as next year's normalised cash flow divided by a capitalisation rate, which is the discount rate less the long-term growth rate. For an illustrative debt-free company with 1,200,000 of normalised cash flow this year, an 18.0 per cent discount rate and 3.0 per cent growth, value is 1,236,000 / 15.0 per cent = 8,240,000. It is a discounted cash flow with a single period, and it gives exactly the DCF answer whenever growth really is constant.
Worked in full in Business Valuation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A stable distribution business has no debt and no surplus cash, so its enterprise value and its equity value are the same number. Its normalised EBITDA, after the owner's salary has been set at market and one-off items removed, is 2,000,000. The figures below are illustrative.
| Item | Value |
|---|---|
| Normalised EBITDA | 2,000,000 |
| Depreciation | 300,000 |
| Tax rate | 25% |
| Capital expenditure | 330,000 |
| Increase in working capital | 45,000 |
| Long-term growth | 3.0% |
Despite its name, the method capitalises a cash flow, and the rate must match whatever is capitalised. A build-up rate prices net cash flow to equity; with no debt, that is the same unlevered free cash flow a DCF uses:
EBIT = 2,000,000 − 300,000 = 1,700,000
NOPAT = 1,700,000 − 425,000 tax = 1,275,000
Cash flow = 1,275,000 + 300,000 − 330,000 − 45,000 = 1,200,000
Capital expenditure sits slightly above depreciation and working capital rises a little, both consistent with a business growing 3.0 per cent a year. The full build is set out in how to calculate unlevered free cash flow.
For a small private company the discount rate is usually built up rather than derived from a listed beta. Each component below is an illustrative assumption, not a market quote:
| Component | Rate |
|---|---|
| Risk-free rate | 4.5% |
| Equity risk premium | 6.0% |
| Size premium | 3.5% |
| Company-specific risk premium | 4.0% |
| Discount rate | 18.0% |
| Less long-term growth | 3.0% |
| Capitalisation rate | 15.0% |
Because the company carries no debt, the cost of equity is also its cost of capital. A levered business would need a weighted rate and a debt deduction afterwards.
Value = CF0 × (1 + g) / (k − g)
= 1,200,000 × 1.03 / (18.0% − 3.0%) = 1,236,000 / 15.0% = 8,240,000
Excel: =CF0*(1+g)/(k-g)
The answer is 6.67 times next year's cash flow and 4.12 times EBITDA. As a check, a five-year DCF on the same inputs gives 4,064,550 for the explicit years and 4,175,450 for the discounted terminal value: 8,240,000 in total, to the unit. The two methods are the same formula when growth is constant from year one, which is the condition the single-period method assumes.
| Discount rate | Growth 2.0% | Growth 3.0% | Growth 4.0% |
|---|---|---|---|
| 16.0% | 8,742,857 | 9,507,692 | 10,400,000 |
| 18.0% | 7,650,000 | 8,240,000 | 8,914,286 |
| 20.0% | 6,800,000 | 7,270,588 | 7,800,000 |
Two points on the discount rate move the value by more than a point of growth, but both matter because the cap rate is a small denominator. The company-specific premium, the least evidenced line in the build-up, is the one that usually decides the answer. A reviewer should ask for its basis before arguing about anything else.
The method is only as good as the claim that next year represents every year. If margins are recovering, a contract is ending or a capital programme is due, the single period misprices the business and a multi-year forecast is required.
Three errors recur, and each produces a confident wrong number:
The book's case values one company three ways and shows that the gap between methods reduces to a few points of implied growth; the free workbook for this case solves the growth rate each value implies, which is the same algebra as the cap rate here run backwards.
The capitalisation rate is the discount rate less the expected long-term growth rate of the cash flow being capitalised. An 18.0 per cent discount rate with 3.0 per cent growth gives a 15.0 per cent cap rate. Using the discount rate itself as the cap rate assumes zero growth and here understates value by 16.7 per cent, at 6,866,667 instead of 8,240,000.
When the business is stable and its next year is representative of every year after it: steady margins, growth near inflation, no major investment programme. It is a DCF with one period. If the forecast has a ramp, a turnaround or a step in capital spending, a multi-year DCF is needed. Here the two give the same 8,240,000 because growth is constant.
Not with a rate built for cash flow. The build-up rate prices net cash flow after tax, capital expenditure and working capital; applied to EBITDA it overstates value. In this case capitalising 2,000,000 of EBITDA at 15.0 per cent gives 13,333,333, 1.62 times the correct 8,240,000. EBITDA belongs with an EBITDA multiple, not a cash-flow cap rate.
This article is one calculation from Business Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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