Capitalization of Earnings

Capitalization of Earnings

Dictionary Definition

This method is used to value a business based on the future estimated benefits, normally using some measure of earnings or cash flows to be generated by the company. These estimated future benefits are then capitalized using an appropriate capitalization rate. This method assumes all of the assets, both tangible and intangible, are indistinguishable parts of the business and does not attempt to separate their values. In other words, the critical component to the value of the business is its ability to generate future earnings/cash flows.

This method expresses a relationship between the following:

• Estimated future benefits (earnings or cash flows)
• Yield (required rate of return) on either equity or total invested capital (capitalization rate)
• Estimated value of the business
  

Plain English

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 may have. 

Why it Matters to You

This is method of valuing a company.  This is a more sophisticated approach than simply taking cash flow and multiplying it by a multiple to get the value.  It involves significant research and knowledge of the type of business and industry. 

This is a method we are seeing PEGs using when evaluating companies to purchase.