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|Capitalization Rates: An Important Aspect in Determining Value
By David Fox, CPA, JD
While most of us would say we know what goodwill is, few would be able to define it in a useful way for business valuation purposes. Yet forensic accountants must consider it in every valuation of a going concern. Understanding goodwill is important because however intangible it is, goodwill clearly contributes to the tangible value of a business, just as any other asset does.
It's possible to capitalize net income, pretax income, income before interest and taxes, or any earnings base. The rates will differ depending on the earnings base used. Determining the correct rate, however, is the key to finding a meaningful value. No matter how valid the method of valuation is, using an inappropriate capitalization rate can render the results meaningless. Therefore, the ability to choose an appropriate capitalization rate is essential for a business evaluator.
What Exactly Is a Capitalization Rate?
How Is the Cap Rate Determined?
For example, Charlotte Webb is looking for the fair market value of her interior design company. The company's net income has been fairly consistent and is expected to continue to be $100,000 annually. Her forensic accountant determines the average investor in Charlotte's market is expecting to make a 20% return. Therefore, Charlotte's company would be worth $500,000 to an investor ($100,000 ÷ 20% = $500,000). The 20% is the capitalization rate for Charlotte's business, capitalizing the income stream to its current value to an investor. If the capitalization rate used were 25%, however, the value of Charlotte's company would be $400,000. You can see what an impact the rate chosen can have on value.
Choosing the Right Rate
David Fox has been a CPA for more than 25 years. He has ample experience as an expert witness for divorce cases, and he also holds a law degree. Located in West Los Angeles, he travels all over southern California for cases. He can be reached at email@example.com or (310) 280-0400.
For more articles on asistance regarding business valuation, visit http://www.divorcemag.com/articles/Business_Valuation/
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