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Exploring topics affecting small businesses in Texas

Capitalization of Earnings Explained: A Fundamental Valuation Method

This is probably the simplest income approach valuation for small businesses.
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What is the Capitalization of Earnings Method?

Capitalization of Earnings is a method to gauge business value. It does this by evaluating the value of its projected profits, considering both its current earnings, the value of both tangible and intangible assets, and future performance expectations.

This approach involves determining the net present value (NPV) of anticipated future profits or cash flows. These values are then divided by what is known as the capitalization rate, or the cap rate for short.

This method is a type of income approach valuation—much like the discounted cash flow method, but simpler. It aims to ascertain a business’s value by analyzing its current cash flow, the annual rate of return, and the projected future value of the business.

It’s particularly useful for businesses with stable and predictable cash flows—allowing potential investors or buyers to estimate the return on their investment.

Keep in mind that although this method isn’t commonly employed in acquisitions, it may arise when probing into the business’s industry and the scale of its operations.

Quick Key Takeaways

  • The Capitalization of Earnings is a technique used to pinpoint a company’s value.
  • The formula is quite simple: Net Present Value (NPV) divided by the Capitalization rate.
  • It’s used to ascertain the returns on invested capital of businesses, as it aids in maintaining business continuity and predicting future cash inflows.
  • But don’t be fooled by its simplicity. To use this formula effectively, you need a solid grasp of the business you’re evaluating.

Better Understanding Earnings Capitalization

Before valuing a business, it’s important to really understand it.

You need to know:

 

  • what it does 
  • what industry it’s in
  • what assets it has
  • how it works

This helps buyers get a good idea of what they might earn from their investment and how the business might grow in the future.

In simple terms, buyers look at how much a company is earning now to figure out how much it might be worth and how much it might earn in the future. Big companies often share this information in financial reports, which helps buyers figure out what they might earn from their investments.

But for small businesses, this process might not show a lot of earnings. That’s because small businesses usually grow slowly, especially at the start.

For example, a relatively new small business is still figuring out:

 

  • how it works
  • who its customers are
  • what industry it’s in
  • what products it sells
  • and who its suppliers are

However, some types of businesses are different. For example, manufacturing plants often have a lot of their capital (or net worth in this context) in tangible, long-term assets like machinery and inventory. In essence, businesses in stable industries are more likely to use this method.

Having a good system for keeping track of earnings is essential in order to make sure that the business continues to get better at what it does and ultimately generate more profit.

How to Determine a Capitalization Rate

For small businesses, the capitalization rate typically fall within the 20% to 25% range. This is the return on investment (ROI) rate that potential buyers usually aim for when considering the purchase of a company.

It’s important to note that the ROI doesn’t factor in a salary for the incoming owner. This figure needs to be calculated separately from the ROI.

Try to look at this example:

  • a small business that generates $500,000 per year and pays its owner an annual salary at the fair market value (FMV) of $200,000
  • In this case, the remaining $300,000 in income is used for valuation purposes

Once all the variables are identified, the capitalization rate can be calculated using a straightforward and simple formula:

operating income ÷ the purchase price

Then, do the following steps:

 

  1. The first step is to determine the annual gross income of the investment. 
  2. Following this, the operating expenses need to be subtracted to find the net operating income. 
  3. Finally, the net operating income is divided by the purchase price of the investment or property to arrive at the capitalization rate.

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What You Should Know

However, small businesses are often sold along with their real estate properties, and it’s important to understand that these two are valued differently and accordingly.

On the other hand, real estate associated with the business is typically valued based on its market value. This takes into account factors such as the property’s location, condition, and comparable sales in the area. Real estate valuation does not directly consider the earnings of the business, but rather the intrinsic value of the property itself.

It’s also worth noting that the capitalization of earnings can also be applied to real estate properties. Real estate properties, especially those that generate income (like rental properties), can be considered assets that produce a stream of earnings.

This explains why the earnings capitalization method is predominantly used in real estate than businesses. Unlike small businesses, real estate generates income in a predictable manner. The assets are the number one factor here.

Capitalized Earnings Method Example

Let’s take this approach into a situational example:

An owner of a small local business in Austin, Texas wants to sell his business.

They consistently generated annual cash flows of $500,000 for the past decade according to their Seller’s Discretionary Earnings. Based on projections, these cash flows are anticipated to persist indefinitely. The company’s annual expenses remain steady at an average of $100,000.

As a result, the business’s annual earnings amount to $400,000, calculated by subtracting the expenses from the cash flows:

($500,000 – $100,000 = $400,000)

To estimate the small business’s value, an investor looks at other risk-free investments that offer similar cash flows. The investor finds a Treasury Bond valued at $4 million that yields an annual return of 1%, or $40,000.

Consequently, the investor concludes that the small business’s value is $4,000,000, as it presents a comparable investment in terms of risks and potential returns.

However, this local small business also owns a piece of real estate property where it operates. The real estate property, based on its location, condition, and comparable sales in the area, is valued at $1,000,000.

Therefore, when considering the total value of the business, the investor must take into account both the value of the business operations ($4,000,000) and the value of the real estate ($1,000,000). This results in a total value of $5,000,000 for the business and the real estate combined.

However, if this small business had a lease on it, that’s a different topic to talk about.

Things to Do Before Capitalization of Earnings

Gather Financial Information

The first move in the capitalization of earnings method is to become a financial detective of sorts. You need to dig deep into the business’s financial history.

This means scrutinizing historical earnings data from financial statements, profit and loss statements, and tax returns.

Consequently, business owners should prepare the necessary documents to perform the capitalization of earnings if they want a valuation before selling their businesses.

Earnings Adjustment

After you’ve gathered all the financial facts, it’s time to do some earnings adjustments. This step involves cleaning up the earnings and removing any non-recurring items like one-time expenses or gains that can mess up the company’s earnings picture.

Consequently, this will give you a clearer view of the company’s core earnings potential.

Plus, don’t forget to consider future earnings projections. Analyzing industry trends, market conditions, and the company’s predictability helps you estimate the company’s sustainable and future cash flows.

Limitations of Earnings Capitalization

The capitalization of earnings method, despite its simplicity, comes with drawbacks.

Take a closer look:

  1. The method used to forecast future earnings might not always be accurate, leading to lower-than-anticipated returns
  2. Unforeseen events can also happen, which can impact earnings and, in turn, affect the valuation of the investment. 
  3. A startup that’s only been operational for a year or two might not have enough data to enable a precise business valuation.

The capitalization rate is intended to mirror the buyer’s risk tolerance, the characteristics of the market, and the company’s projected growth rate. Therefore, buyers should understand what level of risk is acceptable and what return on investment (ROI) they desire.

For instance, if a buyer isn’t clear about their target purchase price, they might end up overpaying for a company or overlook a more fitting investment opportunity.

Remember, the capitalization of earnings method doesn’t account for changes in business strategies or market conditions that could significantly affect a company’s future earnings.

Frequently Asked Questions

How is the capitalization of earnings calculated?

It's calculated by finding the net present value (NPV) of expected future profits or cash flows and dividing them by the capitalization rate.

What is the capitalization rate?

The capitalization rate (or cap rate) is the rate of return on an investment that is used to derive the current value of expected future earnings.

Why is the capitalization of earnings method used?

This method helps investors and business owners estimate the value of a business based on its current and projected earnings, making it especially useful for small businesses without a public trading market.

How is the growth rate factored into the capitalization of earnings?

The expected growth rate of a company influences the projected future earnings, which are then capitalized to determine the business's value.

What is the relationship between the capitalization rate and return on investment (ROI)?

The capitalization rate reflects the ROI that buyers typically seek, helping determine the business's value based on its earnings potential.

How do you adjust the capitalization rate for risk?

The rate should account for potential business risks, with riskier ventures having a higher capitalization rate due to increased uncertainties.

Can this method be used for larger enterprises?

While it can be applied to larger enterprises, it's especially useful for small businesses where other valuation methods might be less viable.

Conclusion

This approach hinges on a straightforward formula—Net Present Value divided by the Capitalization rate.

Its application isn’t as simple as it seems. It demands a robust understanding of the business under scrutiny.

From gathering comprehensive financial data to normalizing earnings, each step requires meticulous attention.

While this method offers valuable insights to uncover the value of a company, it’s essential to remember its limitations and use it as part of a broader investment analysis process to make informed decisions.

Moreover, there are methods other than wholesaling your business, an asset or stock sale, that might snag your attention.

Tsetserra can help you

If you’re a business owner looking for a quick valuation of your business, then our free Business Valuation tool can help you out.

With just a few simple inputs, you can get an estimate of your business value using not only this method we’ve just talked about but a myriad of approaches to narrow down a precise answer to your question.

You can also do your research by knowing what our process is here.

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