Capitalisation of earnings

The Capitalisation of Earnings Method is an income-oriented approach. 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 (capitalisation rate or WACC),
  • The estimated value of the business.

It is important that any income or expense items generated from non-operating assets and liabilities be removed from estimated future benefits prior to applying this method. The fair market value of net non-operating assets and liabilities is then added to the value of the business derived from the capitalization of earnings.

This method is more theoretically sound in valuing a profitable business where the investor’s intent is to provide for a return on investment over and above a reasonable amount of compensation and future benefit streams or earnings are likely to be level or growing at a steady rate.

Example 

Company ABC has five-year weighted average earnings on an after-tax basis of €591,000. It has been determined that an appropriate rate of return for this type of business is 21.32 percent (after-tax). Assuming zero future growth and non-operating assets of €771,000 the value of ABC Company based on the capitalization of earnings method is as follows:

Rounded for calculation purposes1
Net earnings to equity 591,000
Capitalisation rate ÷   21.32%
Total 2,772,000
Value of non-operating assets + 771,000
Marketable controlling interest value 3,543,000

Assuming an indefinite future growth rate would increase the valuation as follows:

If the indefinite future growth rate is 3% the capitalization rate decreases to 18.32% (21.32% -/- 3.00%). The calculation then results in a marketable controlling interest value of €3,997,000.

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