Capitalization Of Earnings

AAA

DEFINITION of 'Capitalization Of Earnings'

A method of determining the value of an organization by calculating the net present value (NPV) of expected future profits or cash flows. The capitalization of earnings estimate is done by taking the entity's future earnings and dividing them by the capitalization rate (cap rate). This will take into account the risk that earnings will stop or be lower than the estimate.

Capitalization Of Earnings



Where:
d = discount rate
g = growth rate

INVESTOPEDIA EXPLAINS 'Capitalization Of Earnings'

This is an income-valuation approach that determines the value of a business by looking at the current benefit of realizing a cash flow now, rather than in the future. The capitalization of earnings is particularly useful when the future earnings can be predicted easily and accurately.

For example, if a company had a business that made $1.2 million last year and that was expected to grow at a 4% rate (plus a 3.25% inflation rate), the annual rate of return needed by a purchaser given the level of risk would be 26%. Expected value using the capitalization of earnings method would be $6.4 million, calculated as:

-$1,200,000/ (0.26 - (.04+.0325))
-$1,200,000/0.1875
-$6.4 million

RELATED TERMS
  1. Net Present Value - NPV

    The difference between the present value of cash inflows and ...
  2. Discounted Cash Flow - DCF

    A valuation method used to estimate the attractiveness of an ...
  3. Capitalization Rate

    A rate of return on a real estate investment property based on ...
  4. Cash Flow

    1. A revenue or expense stream that changes a cash account over ...
  5. Asset Valuation

    A method of assessing the worth of a company, real property, ...
  6. Earned Premium

    The amount of total premiums collected by an insurance company ...
Related Articles
  1. Fundamental Analysis

    Discounted Cash Flow Analysis

    Find out how analysts determine the fair value of a company with this step-by-step tutorial and learn how to evaluate an investment's attractiveness for yourself.
  2. Investing

    Using DCF In Biotech Valuation

    Valuing firms in this sector can seem like a black art, but there is a systematic way to pin a price on potential.
  3. Fundamental Analysis

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    The DCF method can be difficult to apply to real-life valuations. Find out where it comes up short.
  4. Markets

    Intangible Assets Provide Real Value To Stocks

    Intangible assets don't appear on balance sheets, but they're crucial to judging a company's value.
  5. Budgeting

    Which is a better measure for capital budgeting, IRR or NPV?

    In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.All other ...
  6. Markets

    Understanding Economic Value Added

    Discover the simplicity of this important valuation metric. We reveal its underlying ideas and examine each of its components.
  7. Fundamental Analysis

    What is the difference between a capital gearing ratio and a net gearing ratio?

    Understand the definition of gearing in the finance industry, the difference between net gearing and capital gearing ratios and how they are interpreted.
  8. Fundamental Analysis

    What is the difference between interest coverage ratio and DSCR?

    Understand the basics of the interest coverage ratio and the debt-service coverage ratio, including calculations and how each type reflects financial stability.
  9. Investing Basics

    What is the difference between interest coverage ratio and TIE?

    Read about the times interest earned, also known as the interest coverage ratio. Find out why this is an important ratio for investors and creditors.
  10. Investing Basics

    What is accrual accounting used for in finance?

    Read about the accrual method of accounting, its uses and rules, and why it is considered so important for investors, lenders and managers.

You May Also Like

Hot Definitions
  1. Multinational Corporation - MNC

    A corporation that has its facilities and other assets in at least one country other than its home country. Such companies ...
  2. SWOT Analysis

    A tool that identifies the strengths, weaknesses, opportunities and threats of an organization. Specifically, SWOT is a basic, ...
  3. Simple Interest

    A quick method of calculating the interest charge on a loan. Simple interest is determined by multiplying the interest rate ...
  4. Special Administrative Region - SAR

    Unique geographical areas with a high degree of autonomy set up by the People's Republic of China. The Special Administrative ...
  5. Annual Percentage Rate - APR

    The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents ...
  6. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
Trading Center