Despite the conceptual soundness of the discounted future returns method, the subjectivity of future return estimates is a major deterrent to its use. Parties to the negotiations will likely disagree over the assumptions employed in arriving at the estimates. As a result, business valuation often employs a conceptually similar approach that appears to avoid future estimation. This approach is known as capitalized earnings.
We saw that the discounted future returns method computes a present value based on applying a discount rate to the estimated returns of a number of future time periods. The capitalized earnings approach, on the other hand, computes a present value based on applying a capitalization rate to a single amount of present or past returns, as follows:
Period |
Present Value of $1 at 20% |
Cumulative Present Value |
Percent of perpetuity value |
---|---|---|---|
1 |
0.833 |
0.8333 |
0.1667 |
2 |
0.6944 |
1.5278 |
0.3056 |
3 |
0.5787 |
2.1065 |
0.4213 |
4 |
0.4823 |
2.5887 |
0.5177 |
5 |
0.4019 |
2.9906 |
0.5981 |
6 |
0.3349 |
3.3255 |
0.6651 |
7 |
0.2791 |
3.6046 |
0.7209 |
8 |
0.2326 |
3.8372 |
0.7674 |
9 |
0.1938 |
4.0310 |
0.8062 |
10 |
0.1615 |
4.1925 |
0.8385 |
11 |
0.1346 |
4.3271 |
0.8654 |
12 |
0.1122 |
4.4392 |
0.8878 |
13 |
0.0935 |
4.5327 |
0.9065 |
14 |
0.0779 |
4.6106 |
0.9221 |
15 |
0.0649 |
4.6755 |
0.9351 |
16 |
0.0541 |
4.7296 |
0.9459 |
17 |
0.0451 |
4.7746 |
0.9549 |
18 |
0.0376 |
4.8122 |
0.9624 |
19 |
0.0313 |
4.8435 |
0.9687 |
20 |
0.0261 |
4.8696 |
0.9739 |
Note: Annual payments assumed to occur at the end of year.
This formula is equivalent to the present value of a perpetuity discussed above.
What amount of return should be capitalized? First, as discussed previously, any measure of return can be used—a cash flow measure, an income measure, or even revenues or dividends. Second, the return measure may be based on past, present, or even future data. Examples include the following:
- Return for the past 12 months or most recent fiscal year
- An average return, either simple or weighted, for some number of past years
- A normalized current or average return, excluding unusual or nonrecurring items
- A forecast for the current period or a future period.
Most commonly, the use of present returns, or an average of past returns, appears to avoid the estimation problem. But one cannot really avoid estimation. To base a present value on current or past returns implicitly assumes the continuation of such returns in the future.
The capitalization rate is the relevant discount rate, discussed above, minus the assumed rate of growth (or decline) in future returns. As an example, suppose last year’s net income of $200,000 is the amount to be capitalized, that we decide on a relevant discount rate of 20%, and that we expect 3% earnings growth. The capitalized value of the company is:
Present value = Amount of return to be capitalized/capitalization rate
= $200,000/(0.20 − 0.03)
= $200,000/0.17
= $1,176,471
On the other hand, if we anticipate a 3% earnings decline, the capitalized value is:
Present value = Amount of return to be capitalized/capitalization rate
= $200,000/(0.20 + 0.03)
= $200,000/0.23
= $869,565
A capitalization rate for equity returns is the inverse of the familiar P/E ratio commonly cited for publicly traded companies, and thus is sometimes called an earnings–price (E/P) ratio. For example, a company selling at 17 times earnings has an effective capitalization rate of 5.88% (0.0588 = 1/17). In selecting a capitalization rate for a specific business, one could use E/P ratios of reasonably similar public companies as guides. However, when valuing small nonpublic companies, lower P/E ratios (higher E/P ratios and capitalization rates) are typically appropriate, to allow for increased risk. It is not uncommon for small nonpublic companies to sell for 3–10 times earnings.
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