Capitalization of historical earnings
Valuing a business by taking one normalized earnings figure and applying a rate that reflects its risk. It is what a multiple actually is, expressed the other way round.
In more detail
This is the approach behind most lower middle market valuations, whether or not anyone says the name. You establish a single sustainable earnings figure, usually a weighted average of recent years with the most recent weighted heaviest, then capitalize it: divide by a capitalization rate, which is the return a buyer requires minus the growth they expect. A multiple and a capitalization rate are the same statement. A 25% cap rate is a 4x multiple. The reason to think in cap-rate terms is that it forces the question the multiple hides: what return does a buyer need, and how much growth are they willing to assume? It is used instead of a projection-based method because it rests on results that already happened, which is the only thing diligence can verify.
For example
Weighted average earnings of $500,000 and a required return of 25% gives $2.0M. That is identical to applying a 4.0x multiple.
If you are selling
Understand that the weighting matters. A strong most-recent year helps you; one strong year among four weak ones does not carry the valuation on its own.
If you are buying
It anchors value in demonstrated performance rather than a forecast, which is why it survives diligence better than a DCF on a small business.
Related terms
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