The capitalized earnings approach to valuing a business is the most frequently used approach and is almost always included as part of the consideration when valuing a business. It basically involves taking the earnings of the business and multiplying it by a cap rate, which is like the inverse of an interest rate on an investment, to find the current value of the business. The very simplified formula is:

Earnings / Cap Rate = Value of Business

You need to identify 3 things to value a business this way: The earnings, the cap rate, and any irrelevant assets on the statements.

Normalize Earnings

Finding earnings is not as simple as looking at the net income on the latest income statement. Quite often the latest reported earnings are not the normal earnings. You need to look carefully at the income statement and historical statements to try to approximate normal earnings. For example, an owner of a business may be drawing abnormally large salaries for himself for tax purposes, or perhaps he may have not paid himself for a few years to make it look like the business is earning because he anticipates selling it. You can look at net income, income before taxes, EBIT, or EBITDA. Be sure to use what is typically used in the industry so you can compare accurately. Use your judgment on the circumstances to either calculate an average of the past 5 or so year’s normalized earnings, a weighted average that favors recent years, or just the most current year’s earnings.

Choose a Cap Rate

The cap rate, which is like the inverse of a discount rate, is kind of like the interest rate on an investment. Choosing a cap rate is tricky. All business students spend an entire semester banging their heads on their desks trying to sort out this concept. I’m not going to even try to go there again, but for a reference when needed, here’s Investopedia’s attempt at explaining it.

The basic idea is the more risky the business, the higher the cap rate. If earnings are net income, cap rates are usually about 12% to 25%. If earnings are EBIT then maybe the cap rate would be 20% to 33%. You can also look to the industry for an idea of what cap rates might be.

Consider Irrelevant Assets

When a company is put up for sale, the seller will want to be paid for all the assets. But some of the assets may not be producing income or may not be related to the business. Look through the income statement and balance sheet and see if there is anything there that is not related to the business the purchaser intends to own or operate. For example, a restaurant may own an entire building that is not being used, but still including the value of the building in the sale price of the business. Even if the building is generating income through rent, this is not the same business as the restaurant business and will need to be evaluated as two separate businesses.

More:
5 Ways to Value a Private Business

Tags: business valuation, capitalized earnings
Categories: Lesson, Bachelor of Commerce, Entrepreneurship, Business