Main Menu Name: Capital
Capitalizes income (such as rents, dividends, or profits from a business) in order to estimate the value of a business or other asset. It allows seven different capitalization rates to be used simultaneously so that a planner or client can develop a high-low valuation range.
In this article:
Market value is the price a hypothetical willing buyer and willing seller would agree upon assuming both parties have reasonable knowledge of the relevant facts and are bargaining at arms' length. No formula exists that applies to all assets and that will be accepted without question by both the IRS and the courts.
Converting the projected flow of income from a business or asset into its present value, i.e., "capitalizing the income," provides a simple, reasonably accurate, and commonly accepted way of estimating fair market value.
The concept of income capitalization is simple: determine what amount of income is realistic and proper under the circumstances and then apply a capitalization rate that meets the same criterion. In essence the capitalization rate is the desired rate of return; the rate of return an investor would be willing to accept for the given level of risk.
A high-risk investment would equate to a high capitalization rate (which in turn results in a lower value). The asset or business is then presumed to be worth the result when adjusted earnings are divided by the capitalization rate.
But transforming theory into practice is often complex and frustrating. The brief comments below, pertaining to "adjusting" the earnings and selecting the appropriate rate of return may help:
1. Adjustments to "income" (rents, dividends, and business profits). In the case of a business, use five-year average after-tax profits:
- Add back excessive salaries
- Reduce earnings if salaries were too low
- Add back bonuses paid to stockholder-employees
- Add back excessive rents paid to shareholders
- Reduce earnings where rents paid to shareholders were below what was reasonable in the market
- Eliminate non-recurring income or expense items
- Adjust for excessive depreciation
- Adjust earnings for major changes in accounting procedures, widely fluctuating or cyclical profits, or abnormally inflated (or deflated) earnings.
- If there has been a strong upward or downward earnings trend, weight the average to obtain a more realistic appraisal of the company's prospects.
2. Determine the "capitalization rate", i.e., the level of return the investor wants to receive from the business or other asset. The capitalization rate is the amount that is divided into adjusted earnings). The result is the same as multiplying the reciprocal of the rate, (the result of dividing the number one by the capitalization rate). In other words, you obtain the same result by multiplying $100,000 of income by 5 as you do if you divide the $100,000 of income by .20. Deciding on a capitalization rate, consider the following:
- Smaller capitalization rate will result in a higher value. A higher capitalization rate results in a lower value. You can check this by examining the value of a business with an adjusted after tax income of $50,000 a year capitalized at 6 percent (that is, divided by .06), $833,333, and comparing the result with one capitalized at 15 percent (i.e. divided by .15), $333,333.
- Stable businesses with large capital asset bases and established goodwill should be less risky investments. Use a lower capitalization rate than if you were valuing a small business with little capital, financial history, or management depth.
- A risky business, a new business, or a business that stands or falls on the presence or absence of one or two key people should generally be assigned a higher capitalization rate. An investor purchasing this type of business would want a high rate of return as a reward for that risk. (Another way to say the same thing is that such an investor would not make the investment unless a rapid return of capital through a high-income stream was expected).
- There is neither an official IRS mandated capitalization rate nor a "correct" one. Even the IRS uses different rates at different times and under different circumstances. Insist on a capitalization of income illustration showing a high-low range of values since there is no "correct" exact value.
To receive accurate results using the income capitalization method, you must use realistic values for your earning and capitalization rate. The following guidelines will help you to determine appropriate values:
Capitalization Rate: Enter an appropriate capitalization rate.
Remember: One correct or official capitalization rate does not exist. Different rates are used at different times.
Essentially, the capitalization rate is the rate of return you wish to receive from the asset or business. When determining what capitalization rate to use, consider the following:
- The smaller the capitalization rates, the higher the value.
- Less risky investments (such as a stable business with large capital asset bases and strong financial history) are generally assigned lower capitalization rates.
- A business that relies on the presence of only one or two key people is generally assigned a higher capitalization rate.
Adjusted Earnings: Enter the adjusted earnings from the asset, or adjusted profits from the business.
Income includes rents, dividend, and profits from a business. Apply the following adjustments when calculating your income (in the case of a business, use five-year average after-tax profits):
- Increase earnings if salaries were too high; reduce earnings if salaries were too low.
- Add back bonuses paid to stockholder-employees and excessive rents paid to shareholders.
- Reduce earnings if rents paid to shareholders were less than what was reasonable in the market.
- Exclude non-recurring income or expense items.
- Make appropriate adjustments for excessive depreciation, significant changes in accounting procedures, widely fluctuating profits, or abnormally inflated (or deflated) earnings.
- Weight the average to receive a more accurate assessment of the company's prospects if a strong upward or downward earnings trend occur.
The calculation results show the estimated value of a business or other asset. This value is calculated by capitalizing the business or asset's income. To capitalize income, the calculation divides the adjusted earnings by the capitalization rate.
Results are displayed for the capitalization rate specified at the Capitalization Rate input (highlighted in blue), and for six additional rates. By displaying results for seven different capitalization rates, the calculation provides a high-to-low range of values.