Capitalization Of Earnings

What is 'Capitalization Of Earnings'

Capitalization of earnings is 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

BREAKING DOWN '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. Present Value - PV

    The current worth of a future sum of money or stream of cash ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  3. Discounted Future Earnings

    A method of valuation to estimate the value of a firm.
  4. Valuation

    The process of determining the current worth of an asset or company. ...
  5. Forward Earnings

    A company's forecasted, or estimated, earnings made by analysts ...
  6. Forward Price To Earnings - Forward ...

    A measure of the price-to-earnings ratio (P/E) using forecasted ...
Related Articles
  1. Investing

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  2. Markets

    What are Earnings?

    The amount of profit that a company produces during a specific period, which is usually defined as a quarter (three calendar months) or a year.
  3. Investing

    Explaining Capital Employed

    Generally, capital employed refers to all of the assets used in a business that contribute to the company’s ability to earn revenue.
  4. Markets

    IBM Stock: An Earnings Case Study

    Learn the main drivers behind IBM's earnings model and why analysts predict a decline in 2016 followed by a strong recovery in 2017.
  5. Trading

    Time Value Of Money: Determining Your Future Worth

    Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
  6. Markets

    Why Are Global Markets Freaking Out? A Markets Explainer

    Stock markets around the world are off to their worst year ever, but understanding what stocks are will take the mystery out of their movements.
  7. Investing

    Earnings Forecasts: A Primer

    Learn how this key metric is calculated and how it is used to judge market performance.
  8. Trading

    Capitalization Rate

    Capitalization Rate is a financial term most commonly used in the real estate investment industry. It is often simply called the Cap Rate.
  9. Personal Finance

    Everything Investors Need To Know About Earnings

    We go over the concepts behind the excitement over the most important figure in the stock market.
  10. Investing

    Warren Buffett and Berkshire's Productive Assets

    Here are some methods to measure whether an investment will be "productive."
RELATED FAQS
  1. Do you discount working capital in net present value (NPV)?

    Learn why changes in net working capital (NPV) should be included in net present value calculations for analyzing a project's ... Read Answer >>
  2. Do you include working capital in net present value (NPV)?

    Discover why it is important to include changes to working capital as a component in calculating the net present value (NPV) ... Read Answer >>
  3. How do you use net present value to calculate a capital budget?

    Learn about the net present value calculation (NPV) and how the NPV rule is used in capital budgeting to compare the expected ... Read Answer >>
  4. Why is the time value of money (TVM) an important concept to investors?

    Understand why the time value of money is an important concept for investors. Learn when present value and future value calculations ... Read Answer >>
  5. How do you use a financial calculator to determine present value?

    Learn how to utilize a financial calculator to calculate present value. Understand the necessary data, why it is important ... Read Answer >>
  6. What is the lowest capitalization rate before an investment becomes unprofitable?

    Learn about different levels of profitability associated with investments featuring similar capitalization rates. Explore ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center