The Capitalized Cash Flow Method & Real Estate Market: Understanding Cash Flow Valuation
Hi, it's William Jiamin from Learn-Finance-Free. Last time we talked about the cap rate, especially about the cap rate in the real estate market, and I want to further discuss that. Why do we need this so-called capitalization rate? There's a method called capitalized cash flow method, and this method, if you think about it - the real estate valuation method especially using NOI and the cap rate to calculate the property's value - is really a special case of the capitalized cash flow method.
The capitalized cash flow method is a tool used when you value stable, mature companies. We need mature companies because they give you stable cash flow all the way through. If you think about real estate, it's exactly that. When you rent it out, although the economy goes up and down, most of the time it won't affect too much because the leases are long-term, so the cash flow is kind of predictable.
We use capitalized cash flow on private companies. Why? Because with public traded companies, you can use CAPM model, multifactor model, and other methods. If your company is not publicly traded, you can only access some income statements, and then you can use the capitalized cash flow method, especially if it's a stable, mature company.
If you think about it, it's really simple. You just replace or use this divided by capitalization rate. It's a special case for the capitalized cash flow method. Basically, the firm value will be equal to stabilized cash flow divided by the capitalization rate. Think of the NOI (net operating income) as kind of like stabilized cash flow.
So yeah, it's just a special case for this specialized cash flow method. For example, if a company has a cash flow of 10 million USD a year and they have a 10% cap rate, they would be worth 100 million USD. It's a pretty simple calculation. It's just a concept, and I want you guys to make the connection between the NOI divided by cap rate method and why real estate is a special case of capitalized cash flow method.
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