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. 

RELATED TERMS
  1. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate ...
  2. Business Valuation

    Business valuation is the process of determining the economic ...
  3. Capital Flows

    Capital flows entail the path that money travels through corporations, ...
  4. Annual Return

    Annual return is the compound average rate of return for a stock, ...
  5. Modified Book Value

    Modified book value is an asset-based method of determining how ...
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
Related Articles
  1. Investing

    How to calculate ROI for real estate investments

    Calculating return on real estate investments can be difficult. We help you figure it out.
  2. Investing

    Return on investment versus internal rate of return

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  3. Investing

    Methods used in valuing private companies

    There are a few methods for calculating the valuation of a private company. By using financial information from peer groups, we can estimate the valuation of a target firm.
  4. Investing

    How to choose the best stock valuation method

    There are many valuation methods available to investors, each with unique characteristics. Here, we'll explore the most common valuation methods – and when to use them.
  5. Investing

    Evaluating A Statement Of Cash Flows

    The metrics for the Statement of Cash Flows is best viewed over time.
  6. Small Business

    How to Calculate NPV Using XNPV Function in Excel

    Learn how to calculate the net present value (NPV) of your investment projects using built-in functions from Excel using the XNPV function.
  7. Investing

    What Is a Cash Flow Statement?

    The Cash Flow Statement measures whether a company generates enough cash to meet its operating expenses.
  8. Small Business

    Valuing Startup Ventures

    Valuing a company is a difficult task, regardless of the size of the business - but these methods can help.
  9. Tech

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
RELATED FAQS
  1. What is the difference between ROCE and ROI?

    Understand the difference between return on capital employed and return on investment and how analysts evaluate companies ... Read Answer >>
  2. 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 >>
  3. How do net income and operating cash flow differ?

    Net income is the profit a company has earned for a period while cash flow from operating activities measures, in part, the ... Read Answer >>
Trading Center