The Capitalization of Earnings Method is a popular method used to value businesses, especially small and medium-sized enterprises. This method determines the value of a business by estimating the future earnings it is expected to generate and then using a capitalization rate to convert those earnings into a present value. The capitalization rate takes into account the risk associated with the business and the return that investors expect to receive for taking that risk.
To use the Capitalization of Earnings Method, the following steps are typically followed:
1. Establish the expected future earnings
The first step is to estimate the future earnings that the business is expected to generate. This typically involves reviewing the business's financial statements and considering factors such as historical sales trends, the competitive landscape, and any potential threats or opportunities for growth.
2. Determine the appropriate capitalization rate
The next step is to determine the appropriate capitalization rate to use. The capitalization rate represents the return that investors expect to receive for the level of risk associated with the business. This rate can be determined by looking at similar businesses in the same industry, considering economic conditions, and reviewing the business's financial performance and risk profile.
3. Capitalize the expected future earnings
Once the expected future earnings and the appropriate capitalization rate have been determined, the next step is to calculate the present value of the business. This is done by dividing the expected future earnings by the capitalization rate. For example, if a business is expected to generate $100,000 in annual earnings and has a capitalization rate of 10%, its present value would be $1,000,000 ($100,000 / 0.10).
4. Adjust for any outstanding liabilities or assets
The final step is to adjust the present value for any outstanding liabilities or assets that the business may have. If the business has a significant amount of debt, this will reduce the present value. Conversely, if the business has a large amount of cash or other assets, this will increase the present value.
Capitalization of Earnings Method requires an estimate of an ongoing fixed rate of growth benefit stream and a capitalization rate. The capitalization rate represents the required rate of return minus the sustainable growth rate. Capitalization of Earnings Method effectively determines the present value of the Company’s ongoing economic benefit stream growing perpetually at a fixed rate and discounted at the required rate of return. The present value is representative of the amount equal to the Indicated Value of the business.
For this method to be considered, the benefit stream has to be growing at a linear rate. A benefit stream is linear when the estimated future benefits are expected to remain constant or grow or decline at a constant rate. Typically, historical economic income is used to estimate a linear benefit stream. Two methods to estimate future benefits based on historical economic income are:
Unweighted Average Method
An average of the historical economic income is representative of the future expected benefits where all of the past earnings are indicative of the expected future benefits with no existing pattern or trend that would suggest any one year or year’s results are more indicative than the rest of the historical data.
Weighted Average Method
Used when one or more of the historical years are more representative of the future estimated benefits or a trend or pattern exists and is expected to continue. Year figures that are more indicative are weighted heavier than years that are not indicative of future benefits. Most often, the analyst applies a heavier weight to the most recent year’s earnings and a lesser weight to the earlier years.
The Capitalization of Earnings Method is a relatively simple and straightforward method for valuing a business. It is particularly useful for small and medium-sized enterprises that have a relatively stable financial performance and a clear track record of earnings. However, it is important to note that this method can be less reliable for businesses that are expected to experience significant changes in their financial performance or those that operate in industries with high levels of risk or uncertainty.
Conclusion
The Capitalization of Earnings Method is a commonly used method for valuing businesses. It is based on the principle that a business's value is determined by the present value of its expected future earnings, taking into account the level of risk associated with the business and the return that investors expect to receive for taking that risk. By understanding the steps involved in this method, business owners and investors can gain a better understanding of the value of a business and make more informed investment decisions.