How much is a business worth? You may need the answer if a business is owned by your client or the opposing party and is an asset in litigation or settlement. In my new book Introduction to Business Valuation for Matrimonial Lawyers, I look at several of the most common ways to value a business.
One way is through the income approach. The value of a business through the income approach is relatively simple conceptually. It is illustrated through a formula: Value = Benefits / Required Rate of Return. One method within the income approach – the capitalization of earnings method – is where the economic benefits for a single period are converted to value through division by a capitalization rate. This article’s primary focus is summarizing this method’s steps, starting with calculating a normalized benefit stream.
The first step of preparing the capitalization of earnings method is to analyze the income statement. The appraiser needs to analyze and determine if normalization adjustments are required. This process means adjusting for income and expenses that do not have a business purpose or will not continue. For example, suppose a company owner also owns the building that the company operates out of. In that case, the appraiser will look at fair market rental rates and adjust actual rent expenses to remove the effect of owner biases lacking a business purpose.
Once all adjustments are made, the appraiser will analyze the adjusted historical earnings to determine which year, or which combination of years, represents the best proxy for the future benefit produced by the business. A simple average of historical periods may be used if there is no discernable trend in earnings. Or, a weighted average may be used if there is a clear and discernible trend. Still, other years may need to be excluded from the analysis, for example, years affected by COVID.
Once the appraiser has selected the benefit stream, he will have to determine an appropriate rate of return. We call this the capitalization rate. The investment, in this case, is the company being valued. The build-up method (BUM) is one of the methods to determine the capitalization rate. The BUM is determined by adding different risk elements to arrive at the capitalization rate. The standard considerations of the BUM include a risk-free rate of return, an equity risk premium, a size risk premium, an industry risk premium, a company-specific risk rate, and a future long-term growth rate. Each of these elements are important and should be critically reviewed. However, that analysis should ultimately give way to the reasonableness of the overall capitalization rate.
There are a lot of individual parts to determining the benefit and capitalization rate. But ultimately, the appraiser has to consider the benefit reasonable. He must feel confident that the company can produce that benefit in the future. The same consideration must be given for the capitalization rate. Once these components are selected, the benefit is divided by the capitalization rate to determine the value of the business through the capitalization of earnings method.
How about you?
Please ask yourself the following questions the next time you review a valuation report. First, after reading the entirety of the report (including schedules and exhibits), can the business produce the stated benefit in the future? Second, what rate of return would you require to invest the stated value of the report to get the benefit stated? How does that compare to the indicated capitalization rate? Finally, would you buy the business for the stated value? If not, give me a call and let’s discuss your report.