Capitalization and Discounted Returns Valuation Methods

Jeffrey J. Presogna, CPA CVA

It sure would be easier if all businesses were traded on some kind of stock exchange so that an investor could determine the value of that business. The public marketplace where shares of publicly traded companies change hands every day provides investors with a value that is perceived by other investors at a given point in time. How are closely held businesses valued? How does an investor determine the value of a company that does not freely trade on a stock exchange? There are no easy answers to these questions. It is important to note that the methodology to calculate the value of a closely held business follows very closely to that of publicly traded companies. There are practical considerations that must be considered despite these similarities. The quality of information and the primary goals of earnings and benefits will differ greatly in a closely held company in contrast to a publicly held company. This article focuses on valuation methods that can be used to value closely held private companies.

Determining the value of a closely held business or an ownership interest in a business can be a difficult task to undertake. The term "value" will vary depending on the type of valuation. The value of an ownership interest in a company is essentially equal to the present value of the future benefits associated with that ownership interest. Future benefits represent the net cash flows the owner of a business receives from the operations of the business. These cash flows can be in the form of dividends, distributions and salaries and other benefits that are beyond what would be considered normal for that business. The obvious challenge is being able to identify and quantify the future benefits of a business.

There are varying valuation approaches and methods that can be used to value a business. In general, the three basic valuation approaches are the income approach, market approach and the asset-based approach. Within each of these approaches there are varying methods to calculate value. This article is intended to give a brief overview of the income approach, in particular the capitalized and discounted future returns methods.

The capitalized returns and discounted future returns methods are generally considered appropriate valuation methods when the future returns of a business can be reasonably estimated.

Capitalized Returns Method

The capitalized returns method is generally used when there is a reasonable degree of probability that the future benefits (net earnings or net cash flow) of the business can be estimated. Additionally, these future benefits should be estimated to continue at a predictable rate. If the future benefits of a business are likely to be volatile, this methodology will not produce adequate results. The capitalized returns method is calculated by dividing the expected returns of a business by a capitalization rate. The capitalization rate is a function of developing an expected rate of return to an investor. The capitalization rate begins with determining what the return of a risk free investment would be and adding factors for growth and the risk of a particular investment. Capitalization rates can be applied to net earnings, net cash flow and gross cash flow. The capitalization rate may need to be adjusted depending on the earnings stream that it will be applied to. The correct application of this method requires using historical financial statements as a base to predict the future income stream.

Discounted Future Returns Method

The discounted future returns method is used when there is a reasonable degree of probability that the future benefits (net earnings or net cash flows) of the business can be estimated. In contrast to the capitalized returns method, the discounted future returns method assumes that these returns will significantly differ from current operations. This methodology requires a valuator to estimate future returns until a stable earnings level can be ascertained. Similar to the capitalization returns method, a discount rate is applied to each earnings estimate to calculate value. Discount rates are usually applied to net earnings or net cash flows. The value of a business interest calculated by this method depends on prospective economic data. The correct application of this method requires forecasts and projections of net earnings and cash flows of the business. This method would be practical only to the extent that one could provide reasonable and supportable forecasts and projections.

This article has been presented as a general overview of the income approach and the capitalized returns and discounted future returns methods. Because of the complex nature of valuing companies, make sure that you engage the help of a qualified valuation professional.

Mr. Presogna is a CPA and CVA and has provided tax strategies, valuation, merger, and acquisition related services to a wide range of clients. He is Managing Director of the Northeast office of Vercor.