How to Arrive at a Capitalization Rate for a Business

When it comes to mergers or acquisitions, it is important for business owners and involved parties to value a business properly. There are many different factors that go into valuing a business – the company's size and what products or services they offer among them – each of which help determine the best method for arriving at a capitalization rate for a business.

As a business owner, it is important to know the value of your business not only so you can have a better understanding of your company's assets, but also to give yourself some negotiating power when it comes time to sell it. Knowing the true value of your business will give you the leverage to reject offers that do not add up to its value. Without this information handy, you may sell yourself short. There are three broad approaches to evaluating a company's value in advance of determining a valuation using the cap rate. These approaches are: income, asset and market.

The income approach uses a company's income and cash flow – past and projected – to come up with a present-day value. The projected income and cash flow must be adjusted for changes in a company's growth rate or tax codes, while also taking into account inflation and other factors. Along with the company's income, this approach uses a discount rate, which is the rate of return that a person or entity requires in order to proceed with the purchase. Unlike other valuation methods, the capitalizatoin of earnings method can use something as simple as an Excel spreadsheet. This is because this valuation is more straightforward since it does not rely on the comparison of information with similar companies in the same industry.

Discounted Future Income

One of the two income approaches to valuation is the discounted income (or discounted cash flow) method, and it involves making yearly forecasts of a company's income. To use the discounted income method, you must also know someone's required annual rate of return – which is the amount the must receive in order to take on the risk of the purchase. The most straightforward approach involves using the Gordon Growth Model, which takes a company's income and assumes it grows at a constant rate. Using this method, you can find the company's valuation by subtracting its growth rate from the required rate of return, and then dividing its income for one year by that amount.

For example, let us imagine that Company A has a net income of $1 million one year, and it is expected to grow at 7% annually. After analyzing the market and other external factors, an analysis decides that the annual rate of return a buyer would need to take on the risk is 20%. To find the company's value, you would subtract 7% from 20% (equaling 13%), and then divide $1 million by 0.13. In this scenario, the company's value would be $7.69 million.

Capitalization of Earnings Method

With the capitalization of earnings formula, the growth in a company's income is not considered; instead, its value is based on future earnings. To get a company's value, you divide its future annual earnings by the annual rate of return a buyer would need to take on the risk. Using our example from above and assuming Company A expects a net income of $1.2 million next year, its valuation can be found by dividing $1.2 million by 20%, equaling $6 million. The capitalization of earnings method is commonly used when it is determined that accurate growth rate assumptions cannot be agreed upon.

The cost approach to valuation, also known as the asset-based approach, involves valuing a company by analyzing the value of its assets. The value of a company's assets using the cost approach is likely going to be different than what is shown on its balance sheets because they must comply with Generally Accepted Accounting Principles (GAAP) when listing assets on their balance sheet, and these often exclude categories of assets. The cost approach includes all of a company's assets, and the present-day value of those assets is generally lower than the future value of the money earned from them. Because of this, the cost approach is usually the floor of most company's valuations.

The market approach involves valuing a business based on the market prices of its assets or similar companies that have recently sold and adjusting those figures for differences in size, quantities and other company-specific factors. There are two methods under the market approach that are commonly used to come up with a valuation: public company comparisons and precedent transactions.

Public Company Comparables

The public company comparables method involves using specific valuation metrics from publicly-traded companies that are similar to the business in question. The publicly-traded company, known as the "guideline company," should not be chosen just because of industry similarities; it should share similar operational processes, financial structures and supply-and-demand factors as the business that is trying to be valued. It is often difficult to find a direct one-on-one comparison because there are many fundamental differences between private and public companies, so the threshold for comparison should be flexible.

Precedent Transactions

The precedent transactions method involves valuing a company based on the historical transactions of similar companies in its industry. This method is more commonly used in situations where an exit is involved in the equation – such as a merger or acquisition. Using the precedent transaction method is only as effective as the similarities between the companies, so before deciding to use it, you should make sure the companies offer the same products or services, are similar in size and have similar locations. You must also take into account the market conditions at the time of the transactions because that could give a back story that numbers themselves; sales during times like recessions may not be relevant enough to use present-day.

The primary disadvantage of the income approach is its dependence on estimated information instead of concrete data. On one end, a company's growth rate must be estimated, as there is no way to predict its exact annual growth correctly. On the other end, you have to make assumptions about the rate of return a person or entity may need in order to take on a particular risk. While their current risk-tolerance can be accurately assessed, this can change with market conditions and other external factors.

The limitations of the cost approach have to do with how one would go about valuing particular assets – especially intangible ones like trademarks, patents, copyrights and brand value. The value of intangible assets is often up to the discretion of the evaluator, and different evaluators may value particular assets differently. For companies that are intangible asset-intensive, this could cause major differences in valuations.

The main disadvantage of the market approach is the difficulty of finding companies that are comparable enough to provide accurate results. The accuracy of this method is solely depending on the similarities in companies, so without proper similarities, numbers are misleading. There is also the limitation of available data that makes this method less than ideal for particular types of businesses – especially ones in newer industries (like ride sharing, for example). Also, because it relies heavily on comparisons, the method is not as flexible as others.