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Capitalized Earning Approach
A common method of valuing a business is called the Capitalization of Earnings (or Capitalized Earnings) method. Capitalization refers to the return on investment that is expected by an investor. There are many variations in how this method is applied. However, the basic logic is the same.
To demonstrate the logic of this approach, suppose you had $10,000 to invest. You might look at different stocks, bonds, or savings accounts. You would compare the potential return against the risk of each and make a judgment as to which is the best deal in your particular situation.
The same return on investment logic holds for buying a business. Capitalization methods (and other methods) for valuing a business are based upon return on the new owner's investment.
To demonstrate the capitalization method of valuation, let’s look at a mythical and highly oversimplified business. Pretend the business is simply a post office box to which people send money. The magic post office box has been collecting money at the rate of about $100,100 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely. The only expense for this business is $100 per year rent charged by the post office. So the business earns $100,000 per year ($100,100-$100). Because the PO box will continue to collect money indefinitely at the same rate, it retains its full value. The buyer should be able to sell it at any time and get his initial investment back.
A buyer would look at this "no risk" business earning $100,000 and compare it to other ways of investing his or her money to earn $100,000 per year. A near no risk investment like a savings account or government treasury bills might pay about 5% a year. At the 5% rate, for someone to earn the same $100,000 per year that the magic PO box earns, an investment of $2,000,000 (2,000,000*5%= $100,000) would be required. Therefore, the PO box value is in the area of $2,000,000. It is an equivalent investment in terms of risk and return to the savings account or T-bill.
Now the real world of small business has no magic PO boxes and no "no risk" situations. Business owners take risks and have expenses, and business equipment can and usually does depreciate in value. The higher the perceived risk, the higher the capitalization rate (percentage) that the buyer will use to estimate value. Rates of 20% to 25% are common for small business capitalization calculations. That is, buyers will look for a return on their investment of 20% to 25% in buying a small business. For some industries, buyers will often buy businesses at rates of return as high as 33% or even 50%. However, as we'll see below, some businesses have value to some buyers for reasons that have little to do with the amount of money they are earning.
Finally, it is important to point out that the return on investment does not include a fair salary for the new business owner. If the owner must devote time working to realize a profit, he or she must, in theory, be paid a fair value for that work. The owner's fair and reasonable salary must be separated from the return on investment computations. For example, if the magic PO box produced $300,000 per year but required a manager with a fair market salary of $200,000, the income for valuation purposes is $100,000, not $300,000. The fair market value for salary is the important number to use, not the actual salary to the current
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