In one of my previous posts, I identified three sub-parts or methods within the income approach used by business valuation experts to opinion as to the fair value of a closely held company in minority oppression litigation. One of the three sub-parts I identified was the “Capitalization of Income,” approach.
The basic definition of the “Capitalization of Income” approach is what would a reasonable buyer and seller be willing to pay or accept to sell or acquire the income stream generated by the business? This method assumes that the business will generate a certain level of income for an indefinite period of time.
The expert employing the “Capitalization of Income” approach first determines the “income stream,” generated by the company. In order to do so, the business valuation expert must determine an appropriate capitalization or “cap rate,” for the subject company. A cap rate is the inverse of a multiple. It is the number of years that the subject company’s income for which one is paying/receiving to acquire the income stream. For example, a cap rate of 25% means a multiple of 4 – the value of the business is four times its assumed earning stream.
The expert determines the “cap rate” by engaging in a process called the “build up method,” which considers the “growth” and “discount” rates for the subject company. This is done by taking into consideration various considerations such as to the anticipated growth of the company, current income stream the company generates and comparing it to the risk that the current or future income will be reduced or eliminated. In doing so, the expert considers and utilizes published sources regarding expected returns on investment such as the current 20 year treasury note as of date of valuation along with published guidelines that set forth opinions for industry specific risks.
Scott Unger is a Shareholder in Stark & Stark's Lawrenceville, New Jersey office concentrating in Shareholder & Partner Dispute Litigation. For questions, or additional information, please contact Mr. Unger.