The Capitalized Income Method is a valuation technique under the income approach, primarily used to value businesses, income-generating assets, or investments with stable and predictable earnings or cash flows. This method capitalizes the expected income of an asset or business at an appropriate capitalization rate to determine its present value.
Procedures to Perform the Capitalized Income Method
1. Define the Valuation Purpose and Scope
- Establish the objective of the valuation (e.g., transaction, tax purposes, financial reporting).
- Determine the valuation date and the specific income stream being capitalized (e.g., net income, EBIT, EBITDA, or cash flow).
2. Analyze Historical and Expected Income Streams
- Collect historical financial data, typically 3 to 5 years of income statements or cash flow statements.
- Understand the nature of income: whether it is rental income, business earnings, royalties, or other income streams.
3. Normalize the Income Stream
- Adjust historical income to reflect a sustainable level of earnings:
- Remove non-recurring, extraordinary, or unusual items.
- Adjust for owner-specific expenses (e.g., excess salary, personal expenses).
- Account for market-based adjustments (e.g., rent, utilities).
- Consider forward-looking adjustments if the future income stream is expected to differ significantly from historical performance.
Example Normalization Adjustments:
| Item | Amount | Adjustment | Normalized Income Impact |
|---|---|---|---|
| Net Income | $400,000 | N/A | $400,000 |
| Add: One-Time Legal Expense | $20,000 | Add back | $420,000 |
| Less: Excess Owner Salary | $50,000 | Adjustment | $370,000 |
| Add: Market Salary Adjustment | $30,000 | Add back | $400,000 |
4. Determine the Capitalization Rate (Cap Rate)
- The capitalization rate is a critical component, reflecting the risk and expected return of the investment. It is calculated as
Where:
- Discount Rate: The required rate of return considering the risk profile.
- Growth Rate: Expected long-term growth of the income stream.
5. Calculate the Capitalized Value
- The Capitalized Income Method uses the formula:
6. Make Additional Adjustments (if needed)
- Add Non-Operating Assets: Include assets not directly related to income generation (e.g., excess cash, real estate).
- Subtract Non-Operating Liabilities: Deduct liabilities not associated with core operations.
- Apply Control or Marketability Adjustments: Depending on whether the valuation is for a controlling or minority interest.
7. Reconcile and Review the Valuation Result
- Validate the calculated value by comparing it with market multiples or comparable transactions.
- Perform a reasonableness check against industry benchmarks and expectations.
Key Considerations for the Capitalized Income Method
- Stability of Income: This method is most suitable for assets or businesses with stable and predictable income.
- Risk Assessment: The accuracy of the capitalization rate significantly impacts the valuation outcome.
- Growth Assumptions: The method assumes steady growth; for high-growth or declining scenarios, a different method (e.g., Discounted Cash Flow) might be more appropriate.