Capitalisation of earnings valuation

Capitalisation of earnings – The Capitalisation of Earnings Method is an income-oriented approach to valuation modeling. 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:Capitalisation of earnings

  • Estimated future benefits (earnings or cash flows), Capitalisation of earnings
  • Yield (required rate of return) on either equity or total invested capital (capitalisation rate or WACC), Capitalisation of earnings
  • The estimated value of the business. Capitalisation of earnings

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. Capitalisation 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 Capitalisation of earnings

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:

Something else -   Deemed cost
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.

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.Capitalisation of 

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.

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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.

Something else -   Amortised Cost

Capitalisation of earnings

Capitalisation of earnings

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