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.

Capitalization Of Earnings

Where:

d = discount rate

g = growth rate

BREAKING DOWN 'Capitalization Of Earnings'

The capitalization of earnings approach helps investors determine the potential risks and return of purchasing one company rather than another to decide which may offer the best value for the investor's money. For example, imagine a small business has been bringing in $500,000 annually for the past decade and most likely should continue to do so. The business pays $100,000 annually in expenses. Therefore, the business earns $400,000 annually ($500,000 - $100,000 = $400,000.) Because the company should retain its value, a buyer is most likely able to sell it for the same price as what he paid. The buyer could then compare this low-risk investment earning $400,000 annually to other ways he may earn the same amount. For example, he may invest in a treasury bill paying 6% annually. To earn the same $400,000 per year, the buyer has to invest approximately $6.7 million in treasury bills (6,700,000 x 6% = $402,000.) Using this valuation, the small business is worth about $6.7 million.

Determining a Capitalization Rate

Because business equipment typically depreciates over time and business owners have various expenses and risks, the higher the perceived risk, the higher the capitalization rate that is used in determining a company’s value. Rates typically 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 of $200,000 annually uses $300,000 in income for valuation purposes.

Drawbacks of Capitalization of Earnings

If a business owner provides financial statements and tax returns created by a computer program rather than by a person, the numbers may not be in line with generally accepted accounting principles (GAAP), making any assumptions invalid. 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 clearly know what risks he is willing to take and what ROI he wants to receive. If the buyer is unaware of his targeted rate, he may end up paying too much for the company or passing on a deal that may have worked out in his best interest.

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