Income Capitalisation Method of Valuation

One of the various methods of valuing businesses, is the Income Capitalisation Method.

Income Capitalisation Method assumes that the business will continue in operation even after it is sold. It projects the future income of the business based on historical performance adjusting for estimated changes. Historical financial statements and estimates are used for projecting the future financial statements.

Capitalisation rate - The capitalisation rate is the rate of return required to take on operating the business – higher risk leads to higher capitalisation rate. Capitalisation rates are determined based in on the riskiness of the business as well as based on capitalisation rates of comparable companies.

Comparable Capitalisation Rate can be calculated as Net income / Market Value. This would give us the capitalisation rate for comparable companies.

Net Income / Earnings – The Net Income or the Earnings are used for calculating the Market Value of the company. It is important for this figure to be well representative of the true nature and position of the business. For stable businesses, last three years’ average may be used. Some analysts also use the weighted average of the last three years’ net income. Wherever possible, using the forecasted earnings is best used for calculating the market value.

The value of the business would then be calculated as:

Value = Net Income / Capitalisation Rate

Example:

Net Income = Rs 550,000

Capitalisation Rate = 8.5%

Value = 550,000 /0.085 = Rs 6,470,588