What it means
The method assumes a business is worth the stream of profits it can sustain indefinitely. Divide one year of normalised earnings by a rate that captures both risk and growth and you get the present value of that whole stream.
Normalising the earnings is the first real task. You strip out one-off items, adjust an owner's salary to a market rate, remove personal costs run through the books and correct for anything that is not going to repeat.
The capitalisation rate is usually built as a required return minus a long-run growth rate. If investors want 25% from a small private company and you expect 5% annual growth, the capitalisation rate is 20%, which is the same thing as a multiple of five times earnings.
That equivalence is why this method and "earnings multiples" are two ways of describing the same calculation. A capitalisation rate of 20% is a 5x multiple and 12.5% is an 8x multiple, so small changes in the rate move the valuation a long way.
The limitation is obvious once stated: a single year cannot describe a business with lumpy or fast-changing profits. For those, a discounted cash flow model that forecasts several years individually is a better fit, and capitalisation of earnings is then used mainly as a sanity check.
In practice
Real-world examples.
Example
A retiring dentist sells her practice, which has generated steady profit of $310,000 a year for six years. The buyer applies a 25% capitalisation rate, giving a value of $1,240,000, and the pair negotiate around that figure rather than around a multi-year forecast nobody trusts.
Example
An accountant valuing a family bookkeeping firm for a divorce settlement normalises profit by adding back a $40,000 car lease and $25,000 of family travel booked as business expenses. The adjusted earnings raise the valuation materially, and the adjustments become the main point of argument between the two sides.
Example
A private equity analyst uses capitalisation of earnings as a cross-check on a discounted cash flow model of a laundry services group. The two methods land within 8% of each other, which gives the investment committee confidence that the forecast assumptions are not doing something strange.
Formula
Calculation
Business Value = Normalised annual earnings / Capitalisation rate
Capitalisation rate = Required rate of return - Expected long-term growth rate
An owner-managed commercial cleaning firm reports operating profit of $600,000. The owner pays herself $80,000, but a hired manager doing the same job would cost $200,000, so profit must be reduced by the $120,000 difference. Normalised earnings are $600,000 - $120,000 = $480,000.
A buyer requires a 25% return from a business of this size and risk and expects 5% long-term growth, so the capitalisation rate is 25% - 5% = 20%.
Business value = $480,000 / 0.20 = $2,400,000.
The same answer comes from the multiple: 1 / 0.20 = 5, and $480,000 x 5 = $2,400,000. Note how sensitive this is. If the buyer demanded a 30% return instead, the rate becomes 25% and the value falls to $480,000 / 0.25 = $1,920,000, a drop of $480,000 from a single assumption.Case study
Seen in the real world.
Kettleworth Signage is an invented company presented here as an illustrative example. It printed and installed shopfront signs, had traded for eleven years, and produced remarkably consistent profits because roughly 70% of its work came from repeat retail clients on rolling contracts.
When the two founders decided to sell, their first asking price came from multiplying last year's reported profit of $540,000 by a rule-of-thumb multiple of six, giving $3,240,000. The buyer's adviser normalised the earnings instead, removing a $95,000 insurance recovery that would not repeat and adding $60,000 for a below-market rent paid to a company the founders also owned, which produced normalised earnings of $505,000.
Using a required return of 24% against expected growth of 4%, the adviser applied a 20% capitalisation rate and arrived at $2,525,000. The deal eventually closed near that figure, and the founders' main lesson was that the earnings number, not the multiple, was where the money had been hiding.
Watch out
Common mistakes.
- Using last year's reported profit without normalising it. One-off gains, owner perks and below-market rents all distort the base, and the error is then multiplied by five or more.
- Applying the method to a fast-growing or cyclical business. A single year is a poor description of a company whose profits are doubling or swinging with a commodity price.
- Treating the capitalisation rate as a discount rate. The capitalisation rate is the discount rate minus growth, and confusing the two systematically undervalues growing businesses.
Questions
People also ask.
What is a typical capitalisation rate for a small business?
Rates of roughly 15% to 33% are common, equivalent to multiples of about three to seven times earnings, with riskier and more owner-dependent businesses at the higher end.
Should I capitalise profit or cash flow?
Either works provided the rate is built consistently for the measure chosen, though many valuers prefer a cash-based figure because it is harder to manipulate.
Does this method handle debt?
It values the business operations, so you normally deduct interest-bearing debt and add surplus cash afterwards to reach the value of the equity.
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