Valuation Formulas: The Income Method

Formulas for putting a value on a business: The Income Method

Looking at the asset value of a business can be complicated, as the numbers on the balance sheet may not accurately reflect the actual value of things like building and equipment after depreciation, or land value if the business is more than a few years old.

For this reason, some valuators prefer to use the company's income before depreciation, interest and tax (IBDIT) are deducted to predict future earnings and the overall value of the company. IBDIT should reflect the true nature of the business, and as such should be based on the financial records averaged over the last 5 years, 3 years, or current year if that is more appropriate.

Calculating Interest Before Depreciation, Interest and Taxes (IBDIT)
When using this method, it is important to study the overall business, and adjust the value assigned to IBDIT for considerations that can be found both on and off the balance sheet.

For example, upcoming building or equipment maintenance will not be found on the balance sheet, but if your analysis shows that there will be an increase in costs of this nature, then you should reduce IBDIT by a reasonable estimate of maintenance costs. Similarily, unusual profits or losses, such as the sale of a major asset, should be removed from your calculation of IBDIT. When doing the calculations you may also want to replace the current owner's salary on the operating expense section of the seller's income statement with the salary that you feel would be reasonable for the new management of the company.

When calculating IBDIT, you should not factor in possible growth of income due to further investment in or expansion of the business; you only pay the seller for the business performance as it exists now.

Coming up with a Capitalization Rate
Once you have determined IBDIT, you need to come up with an appropriate capitalization rate, which you will use as a multiplier. Here are the key factors that go into this equation:

Current interest rate on any loans or mortgages used to purchase the business.
The amount of cash you put into the business, also known as your equity investment, is another factor. Since you are making an investment in the company, you should consider what return you expect to get on your investment (ROI), in percentage.
A risk factor should also be added, as this investment will likely be much riskier than purchasing treasury bills or other securities.Combing these three percentages, you should weigh each one accordingly to come up with an overall average.

Capitalization rate: sample calculation
Here is a sample calculation for someone purchasing a business for $100,000:

Bank loan:	$60,000 @ 8.9% per annum
Equity investment:	$40,000 @ 15% per annum (the return you want to get on your investment)
Risk factor:	3%

Investment	Weight	Interest Rate	Weighted Capitalization Rate (weight x interest rate)
Bank Loan	60%	8.9%	0.60 x 8.9% = 5.34%
Equity investment	40%	15%	0.40 x 15% = 6.0%
Sub-total	--	--	5.34 + 6.0 = 11.34%
Plus risk factor	--	--	3%
Total	100%		11.34% + 3% = 14.34%

Process of calculating a company's value using the Capitalized Earnings Method:

Use the seller's income statements to estimate Income before Depreciation, Interest and Tax (IBDIT).
Adjust IBDIT for potential increases in expenses after the business is purchased due to building, equipment and fixtures/furniture maintenance and replacements.
Now that a final value for IBDIT has been calculated you need to calculate a capitalization rate. This rate is based on the interest you must pay to the bank, the return on investment you want to see from your original investment, and a risk factor that you feel is appropriate for the purchase of this business. (see above example)Once you have the IBDIT and a capitalization rate, you determine the purchase value of the business by dividing IBDIT by the capitalization rate:

IBDIT

Capitalization rate