What is Capitalization 2.0?
Capitalization 2.0 eliminates constant-capital-structure and no-debt-principal-repayment assumptions in current capitalization method. Capitalization 2.0 values a constant growth business with debt principal repayment and changing capital structure. It uses Advanced Growth Model (AGM) formula instead of the Gordon Growth Model (GGM) formula. Capitalization 2.0 also shows pro-forma financial statements of a buyer who pays a value derived using GGM and AGM.
Why Capitalization 2.0?
Value of a business is the present value (PV) of its future cash flow distributed to its investors. To emphasize, such value is PV of cash flow, NOT PV of any other economic metric.
The method to calculate such PV is called capitalization when one assumes that the business is growing at a constant rate. Capitalization is used in the single-period capitalization method (this method is used when the business is assume to grow at a constant rate starting from the date of valuation), or in determining the Terminal Value at the end of n periods in the multi-period DCF method, where one assumes that the business will grow at a constant rate starting at the of period n.
Today, capitalization method uses Gordon Growth Model (GGM) formula, which is V = X1/(k-g), where V is the value of the firm, X1 is the cash flow distributed to the investors in year-1, k is the cost of capital and g is the constant growth rate of the numerator X1. GGM formula was developed by Prof. Myron Gordon in 1956 as a dividend distribution model to determine equity value. It is used today as a tool to value a business. The GGM formula assumes that a) the cash flow X1 will grow at a constant rate g forever, b) the capital structure used in computing the cost of capital k will remain constant forever, and c) the debt principal will never be repaid.
However, lenders who provide the debt, expect the debt amount, full or partial, to be repaid over the debt amortization period. This is true even under the constant growth assumption. Such debt repayment includes both the principal and the interest on the debt. When debt principal is repaid, the cash flow X1 of the business cannot grow at a constant rate even if the business continues to grow at a constant rate. Further, as debt principal is repaid, the capital structure of the business continuously changes. Thus, both assumptions of the Gordon Growth Model (GGM) discussed above can never be true if debt must be repaid under the constant growth assumption.
Industry has continued the use of GGM for capitalization despite the above problems due to lack of a solution. Now, Capitalization 2.0 provides the solution. Capitalization 2.0 uses Advanced Growth Model (AGM) formula. AGM values a firm while a business is growing at a constant rate with debt repayment and changing capital structure.
AGM formula was developed by Mike Adhikari in 2005. An article on AGM was published in Business Valuation Update in June 2009. The article explains the steps to derive the AGM formula. (Note: The GGM formula derivation takes less than one page; the AGM formula derivation takes 20 pages.)
GGM vs. AGM results
- GGM consistently over-values a business. The amount of overvaluation is significant; 10% to 50% overvaluation is common.
- Use of GGM formula means that equity holder will be paid dividends before making any debt principal repayment, and
- Use of GGM formula also means that as the business grows, business will increase its debt level (to maintain constant capital structure) and such additional debt will be distributed to equity holder as dividend.