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 determined by taking the entity's future earnings and dividing them by the capitalization rate (cap rate). This is an income-valuation approach that determines the value of a business by looking at the current cash flow, the annual rate of return, and the expected value of the business.

BREAKING DOWN 'Capitalization of Earnings'

The capitalization of earnings approach helps investors determine the potential risks and return of purchasing a company.  

Determining a Capitalization Rate

Determining a capitalization rate for a business involves significant research and knowledge of the type of business and industry.  Typically, rates used for small businesses are 20% to 25%, which is the return on investment (ROI) buyers typically look for when deciding which company to purchase.

Because the ROI does not include a salary for the new owner, that amount must be separate from the ROI calculation. For example, a small business bringing in $500,000 annually and paying its owner a fair market value (FMV) of $200,000 annually uses $300,000 in income for valuation purposes.

When all variables are known, calculating the capitalization rate is achieved with a simple formula, operating income/purchase price.  First, the annual gross income of the investment must be determined.  Then, its operating expenses must be deducted to identify the net operating income.  The net operating income is then divided by the investment's/property's purchase price to identify the capitalization rate.

Drawbacks of Capitalization of Earnings

Evaluating a company based on future earnings has disadvantages.  First, the method in which future earnings are projected may be inaccurate, resulting in less than expected yields.  Extraordinary events can occur, compromising earnings and therefore affecting the investment's valuation.   Also, a startup that has been in business for one or two years may lack sufficient data for determining an accurate valuation of the business. 

Because the capitalization rate should reflect the buyer’s risk tolerance, market characteristics, and the company’s expected growth factor, the buyer needs to know the acceptable risks and the desired ROI. For example, if a buyer is unaware of a targeted rate, he may pay too much for a company or pass on a more suitable investment.

Capitalization of Earnings Example

For the last 10 years, a local business has enjoyed annual cash flows of $500,000; based on forecasts, these cash flows are expected to continue indefinitely. The business's annual expenses are a constant $100,000. Therefore, the business earns $400,000 annually ($500,000 - $100,000 = $400,000).  To determine the business's value, the investor examines other no-risk investments with similar cash flows.  He identifies a  $4 million Treasury bond yielding 10% annually, or $400,000.  As a result, he determines the value of the company as $4,000,000 because it is a similar investment in terms of risks and rewards. 

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