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Capitalizing Income Streams Into Asset Value

As nice as it is to improve profitability, that is not the end of the story.  Because the income stream a business can generate is capitalized into its value, an increase in profitability can dramatically increase the business owners' wealth.  Let me demonstrate with a hypothetical example. 

If a company is earning pretty much year in and year out $100,000, it has a value of perhaps $500,000.  That is derived by multiplying the income by a number estimated by an appraiser or potential purchaser. That "number" is not pulled out of the air, but is the inverse of the "cap" rate that a business of that type in that industry with that track record normally requires.  Huh? 

In other words, an investor will look at many alternative investments in which to invest his or her money.  The investment that pays the highest returns for the risk he or she is willing to take is where the money will be invested.  A sure thing, such as a 30 year US government bond may pay 5%.  Investors may require a much higher potential return for something more risky, such as a 25% for a start up company, or higher, to compensate them for the risk that they will actually lose money. 

If the government bond is paying $100 per year interest, and the rate of return the investor requires from that kind of an investment is 5%, the bond is worth $2000 on the market.  That is 100/.05 = $2,000.  On the other hand, if the more risky business is earning out the same $100 per year, the value is $100/.25 = $400.  In other words, the capitalization or "cap" rate applied to the bond of 5% translates into an income multiplier of 20, so $100 x 20 = $2,000.  For the riskier company, the cap rate of 25% translates into a multiplier of only 4, so the $100 x 4 = $400. 

For relatively small business that are fairly stable, a multiplier of 5 is not unusual.  However, if the expectation is for great things to come, the multiple can sky rocket.  This is the same concept of the P/E ratio in the stock market.  When interest rates are low, the stocks' Price to Earnings or "P/E" ratio tends to rise. When expectations of boom times ahead run rampant, the P/E ratio rises, because the P/E ratio is calculated based on current earnings, while the expected future prices are being capitalized based on expected future earnings. Investors bid the prices up now, because they expect the prices to be even higher amount later.  When expectation of a specific company's future are rosy, the multiplier applied to future expected earnings may even be very high, such as for which has not yet even earned a profit.

The importance of this concept is that with the hypothetical company we were discussing, if income were to rise from $100,000 to $200,000, if the same multiplier of 5 were used, the value of the company would rise from $500,000 to $1,000,000.  The business owner would be much wealthier, as the increased income has been "capitalized" into the value of the business.