Income Approach
The Capitalization of Earnings method converts a single period of normalized earnings into an indication of value by dividing by a risk-adjusted capitalization rate. It's the most straightforward income approach — best suited for businesses with stable, predictable earnings that are expected to continue indefinitely.
Under USPAP Standard 9, the Income Approach values a business based on anticipated economic benefits. The Capitalization of Earnings method is a direct capitalization technique that converts a single period of representative earnings into an indication of value. Per NACVA and IBA standards, the cap rate must be built from market-derived components — not arbitrarily assigned — and the appraiser must explain the basis for each component of the build-up. USPAP requires that capitalization rates and projections be based on reasonable and appropriate evidence.
Standards references: USPAP Standard 9, Ibbotson/Duff & Phelps Build-Up Method, NACVA Professional Standards, Kroll Cost of Capital Navigator
Calculate the business's sustainable, normalized earnings — typically SDE for Main Street or EBITDA for mid-market. Apply multi-year weighted averages to smooth cyclical variations. Remove one-time, non-recurring items.
The cap rate represents the required rate of return an investor demands. For small businesses, it's built up from: Risk-Free Rate (20-year Treasury yield) + Equity Risk Premium + Size Premium + Industry Risk Premium + Company-Specific Risk Premium (CSRP). For Main Street businesses, total cap rates typically range from 20% to 33%.
If the business has a sustainable long-term growth expectation, subtract the growth rate from the discount rate to derive the cap rate. Cap Rate = Discount Rate − Long-Term Growth Rate. For no-growth businesses, the cap rate equals the discount rate.
Indicated Value = Normalized Earnings ÷ Capitalization Rate. For example: $200,000 SDE ÷ 25% cap rate = $800,000 indicated value. The lower the cap rate (lower risk), the higher the value.
Business Value = Normalized Earnings ÷ Capitalization Rate
Where Cap Rate = Discount Rate − Sustainable Growth Rate
MainStreetOS™ builds the discount rate (and subsequently the cap rate) using the Build-Up Method, which is standard practice under USPAP and NACVA guidelines for privately held businesses:
The CSRP is where broker judgment matters most. MainStreetOS™ uses a 15-factor weighted scoring system across Business & Industry, Financial, and Operational risk categories.
Agent 3 executes Cap of Earnings by:
Capitalization rates must be based on reasonable and appropriate evidence. The appraiser must weigh historical information and trends, current market factors, and reasonably anticipated events. The selection of the earnings period (single year vs. weighted average) must be explained and supported.
The industry-standard method for constructing discount and capitalization rates for privately held businesses. Components include the risk-free rate, equity risk premium, size premium, industry risk premium, and company-specific risk premium (CSRP). All components must be sourced from recognized market data.
The capitalizer/divisor and the investor must be defined in terms of the same measure of investment return. A pre-tax capitalization rate must be applied to pre-tax earnings; post-tax to post-tax. Mismatching produces materially incorrect valuations.
Requires that the valuation analyst consider and document the basis for all significant assumptions, including the discount rate, capitalization rate, and any adjustments to normalize earnings. The analyst must explain why the capitalization method was selected.
MainStreetOS™ builds your cap rate from 15 risk factors and applies it alongside four other methods.
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