WFU Law School
Law & Valuation
5.2 Business Valuation - Income Methods

5.2.1 Income Method (Capitalization of Earnings)

The most widely-used method to compute the value of a business looks at the present value of anticipated future income or cash flow generated by the business. In effect, the valuator capitalizes the company's current earnings. Like other methods for valuing financial instruments, this method relies on the discounted cash flow (DCF) model. Earnings projections, extrapolated from the company's accounting statements, are discounted using a capitalization rate (or multiplier) that takes into account the buyer's required risk-based rate of return and a factor for future growth.

The DCF method, or the capitalization of earnings method, is well-suited for valuing a company whose earnings can be reasonably predicted—constant earnings, growing earnings, or intermediate term growth followed by constant earnings. The key is thoughtful forecasting, supported by articulated and reasonable assumptions. Often DCF valuations will be based on "best," "worst" and "most-likely" case scenarios.

Estate and gift tax. The IRS has provided guidelines for valuing closely held corporations. Revenue Ruling 59-60 (1959-1, C.B. 237) and Section 2031 of the Internal Revenue Code. These guidelines, used by the IRS in estate and gift tax cases, have been used by courts in equitable distribution cases.

Section 1 states: "The purpose of this Revenue Ruling is to outline and review in general the approach, methods and factors to be considered in valuing shares of the capital stock of closely held corporations for estate tax and gift tax purposes." (More>>)

Example

Dr. and Mrs. Nehorayoff divorced. He owned a half-interest in a closely held medical practice, which interest earned at least $50,000 annually, over and above a reasonable salary. In an equitable distribution proceeding, how would the court determine the value of the business by capitalizing earnings?


Answer: The court considered, among other things, the earnings record and the risk involved -- each reflecting an assessment of the business -- to "capitalize" the earnings figure. Rev. Rul. 59-60 § 6. In making these judgments, expert testimony was essential, and the court considered the expert's reason for adopting a particular earnings stream and choosing the multiplier.

Based upon the nature of this enterprise, its history and prospects and "all the facts and circumstances of this case" -- judges fudge, too -- the court looked at actual earnings to impute future earnings and then said the appropriate capitalization factor would be in the range of 3 to 4 (a discount rate of 25% - 33%). From this the court concluded the value of Dr. Nehorayoff's interest in the business using capitalization of net earnings to be $200,000.

For an excellent discussion of this method, see Nehorayoff v. Nehorayoff, 108 Misc. 2d 311, 437 N.Y.S. 2d 584 (1981).

 

Examples

How well do creditors do in valuing bankrupt firms and approving plans in bankruptcy? See Gilson, Hitchhikes, Ruback.

Valuation of a sole proprietorship involves the same issues. See "Estimating Damages Due to the Loss of An Established Service Clientele: A Market Value Approach for Cases of Self Employment."


Student paper

For a paper discussing problems associated with large income-producing properties such as hotels, see Jenny Pruitt, A Valuation of a Hotel: Determining the "Fair" Value of Income-Producing Real Estate.

5.2 Business Valuation - Income Methods

©2003 Professor Alan R. Palmiter

This page was last updated on: April 5, 2004