Understanding the Capitalisation Factor - Business Valuations

The most common method of valuing small, profitable businesses is the Future Maintainable Earnings (FME) method. This approach is simple, widely accepted, and forms the basis for many business sale transactions and legal valuations. Yet, one concept within this method is frequently misunderstood: the capitalisation factor.

Future Maintainable Earnings x Capitalisation Factor = Business Value

This is the formula at the heart of the FME methodology. But let’s unpack what it really means, and why understanding the capitalisation factor properly is critical.

What Is a Capitalisation Factor?

The textbook definition of a capitalisation factor is:

“Any multiple or divisor used to convert anticipated economic benefits of a single period into value.”

Clear as mud? You’re not alone.

In real terms, the capitalisation factor represents the expected rate of return adjusted for the risk of the investment. It is the inverse of the return you expect to earn every year forever, based on the current earnings of the business.

A capitalisation factor of 3 means you’re expecting a 33.3% return per annum indefinitely.

It does not mean you’ll get your money back in three years.

The Risk-Return Relationship

Here’s where many business owners and even some advisors go wrong. They see a multiple of 3x and assume:

“Great, I’ll recoup my investment in three years.”

But this isn’t how it works. That assumption implies a 0% return, which no rational investor would accept for a business with any risk.

A 33.3% expected return implies significant risk. You want that high return because:

• There’s a chance the business won’t earn $100,000 every year,

• And there’s a risk you might lose your capital altogether.

Example: Valuing a Business with FME

Let’s say a business has estimated future maintainable earnings of $100,000 per year. The appropriate capitalisation factor, based on industry risk, market conditions, and business strength, is 3.

Value of Business = $100,000 x 3 = $300,000

That 3x factor translates to a capitalisation rate of 33.3% (1 ÷ 3).

This reflects the expected rate of return required to justify the investment, given its risk profile.

A Shortcut to Discounted Cash Flow

The FME method is essentially a simplified version of the discounted cash flow (DCF) model, with a key assumption: zero growth (or growth only keeping up with inflation).

Here’s how the discounted cash flow would look using a 33% discount rate:

Year	Cash Flow ($'000)	Discount Factor (33%)	Present Value ($'000)
1	100	0.7500	75.00
2	100	0.5625	56.25
3	100	0.4219	42.19
4	100	0.3164	31.64
5	100	0.2373	23.73
6	100	0.1780	17.80
7	100	0.1335	13.35
8	100	0.1001	10.01
9	100	0.0751	7.51
10	100	0.0563	5.63
11–50	...	...	~16.00 (total)
Total			$300,000

This table confirms that $100,000 per year in perpetuity, discounted at 33%, has a present value of $300,000.

Final Thoughts

Understanding the capitalisation factor is essential in business valuation. It’s not just a multiple, it reflects the risk appetite of potential buyers and the stability of future income. Misunderstanding this concept can lead to significantly overvaluing or undervaluing a business.

If you’re considering buying or selling a business, or need an expert opinion for legal or financial purposes, reach out to our team at Dolman Bateman. We specialise in business valuation and forensic accounting, helping you make confident decisions based on sound financial analysis.

Meeting with Arnold Shields

Book Now

Disclaimer:

The information provided in this article is general in nature and does not constitute personal financial, legal or tax advice. While every effort has been made to ensure the accuracy of this content at the time of publication, tax laws and regulations may change, and individual circumstances vary. Dolman Bateman accepts no responsibility or liability for any loss or damage incurred as a result of acting on or relying upon any of the information contained herein. You should seek professional advice tailored to your specific situation before making any financial or tax decision.