Capitalization of Earnings: Definition, Uses and Rate Calculation

What is Capitalization of Earnings?

Capitalization of earnings is a method of determining the value of an organization by calculating the worth of its anticipated profits based on current earnings and expected future performance. This method is accomplished by finding the net present value (NPV) of expected future profits or cash flows, 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.

Key Takeaways

  • Capitalization of Earnings is a method of establishing the value of a company.
  • The formula is Net Present Value (NPV) divided by Capitalization rate.
  • To properly apply the formula requires a strong understanding of the business being reviewed.

Understanding Capitalization of Earnings

Calculating the capitalization of earnings helps investors determine the potential risks and return of purchasing a company. However, the results of this calculation must be understood in light of the limitations of this method. It requires research and data about the business, which in turn, depending on the nature of the business, may require generalizations and assumptions along the way. The more structured the business is, and the more rigor applied to its accounting practices, the less impact any assumptions and generalizations my have.

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 1% annually, or $40,000. 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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