Capitalization of Earnings

What is the “true value” of a business for divorce purposes? Is it simply a matter of assets minus liabilities? What about the “value” of the business’ good name and reputation? When it comes to buying and selling a business, the buyer determines the true value. The buyer who is ready, willing, and able to buy the business will have a “perceived value” in his/her head that will determine the dollar amount.

In a divorce, there are many ways to value a business. One method that is quite common is called “capitalization of earnings.”

What is capitalization?
Capitalization is the return that an investor expects on an investment.

To understand this concept, let’s create an imaginary business called Widget Inc. After expenses, Widget Inc. shows a $10,000 annual profit. Widget has shown a $10,000 annual profit for the last twenty years and it is likely to continue to show a $10,000 annual profit for another 20 years or 50 or indefinitely after the divorce.

The key point about Widget Inc. is this: because it will continue to collect revenue indefinitely at the same annual rate, the business retains its full value. This means that the buyer should be able to sell it at any time and recoup his initial investment.

Widget Inc. would be considered a “minimum risk” business. A buyer would need to compare an investment in Widget to a no-risk investment.

What is a no-risk investment?
A savings account, government treasury bill, municipal bond, etc.

Let’s assume the buyer invests in a treasury bill that pays 8% a year. In order to earn the same return on investment as with Widget Inc., an investment of $125,000 is necessary: $125,000 x 8% = $10,000.

Using this calculation gives Widget, Inc. a value is in the area of $125,000 and makes it an equivalent investment in terms of risk and return to the treasury bill, for divorce purposes.
Widget, Inc. is an imaginary business. In real life, businesses are never “minimum risk” or “no risk.” There’s no such thing as permanently fixed revenue and expenses. And there’s not a business in the world where equipment doesn’t depreciate in value. Every business is a “risk.”

The capitalization rate (a percentage amount) that is used to estimate value grows in direct proportion to the perceived risk with which a company operates. A weather-dependent ski lodge has a different perceived risk than a sneaker store at the local mall. It’s not uncommon that capitalization rates of 20-25% are applied to small businesses in a divorce.
In other words, when buying a small business, a buyer will be looking for an ROI of 20-25%.

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