Capitalization of Earnings

Updated on May 3, 2024
Reviewed byDheeraj Vaidya, CFA, FRM

What is Capitalization of Earnings?

Capitalization of earnings is a process of estimating the value of a company through its present earnings and cash flow that help estimate the company’s future earnings and profits. Its purpose is to help investors better understand and estimate future profits and growth of the company to plan their investments.

What is Capitalization of Earnings?

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The capitalization of earnings method calculates business valuation by considering the current earnings of a business, its cash flows, and the annual rate of return for investors to determine future profits of the business. To calculate this valuation, an analyst requires good knowledge and insight into the working of the company and its revenue-generating operations.

Key Takeaways

  • Capitalization of earnings refers to determining an investor or business’s future rate of returns or income.
  • This method considers an investment or business activity’s current total earnings or cash flow to determine capitalization on earnings.
  • Its calculation includes the net income divided by the capitalization rate. This figure reveals the true potential of any business activity for an investor or analyst.
  • A good and intrinsic knowledge of the business, industry, and revenue-generating operations allow an investor or business to have realistic and likely returns.

Capitalization Of Earnings Explained

The capitalization of earnings method assists in determining the business valuation for investors and other stakeholders. Thus, capitalization on earnings estimates the gross income generated over a period that also applies to subsidiary holdings of a business, its product line, etc. This capitalization rate, or the rate of returns for the investor, weighs against the gross income generated.

To determine the business valuation based on its earnings, it is important to first know about the business profile, industry, and operations of a business. These factors assist an investor in having more realistic expectations of their gains or returns. These insights also allow an investor to build on the existing growth trajectory of a company and predict future outcomes.

Thus, investors may determine the value of a business through its current earnings and anticipate its future profits. In addition, the annual reports mention this information on business revenues and profits from core operations for large, renowned, and established enterprises. Thus, allowing investors to estimate their returns on investment.

On the other hand, small business capitalization of earnings for investors may not be very high. It is because the capitalization rate for small businesses tends to grow at a slower pace due to the initial stages of the business. For example, in the initial stages, a small business will still learn more about organizing its operations, markets, customers, industry, product line or vendors, etc.

Alongside these factors, rigorous and disciplined accounting systems help ensure better accounting of a business’s net income and costs. Thus, as the business grows, it discovers how to ensure economies in its operations while maximizing output and profits. These factors also attract investors to invest higher capital as they hope for increasing returns.

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How to determine?

Capitalization of earnings is important for an investor to know the estimated return on investment (ROI). Similarly, the investor needs to be aware of risks that can occur in the process and aim for achievable targets or returns on investments. Thus, accounting plays an important role in eliminating or restructuring loss-making units of a business.

Investors should intrinsically know the business, industry, and revenue-generating operations to have expectations closer to actual returns. It will also help the investor to predict or expect stabilized portfolio and returns.

Thus, an investor should gain adequate knowledge about a business and its operations to calculate capitalization on earnings. Its formula includes the net present value (NPV) divided by the capitalization rate.

To calculate the same for a larger enterprise, the weighted average of earnings over time divided by the capitalization rate helps establish the value of a company. The capitalization rate assists both small and large businesses determine the rate of returns for owners, investors, and other stakeholders.

A start-up business might have more variable annual earnings and return on investment (ROI) compared to mature businesses in the same industry. Thus, regular earnings divided by capitalization rate can also assist in finding the business valuation.

Example of Capitalization of Earnings

Let us understand this concept better with a capitalization of earnings example,

A supermarket chain evaluates a decision to open a new store on a busy street and wishes to estimate its returns or capitalization rate. Thus, it refers to the annual earnings of one of its existing stores having a similar location to determine their returns on investment for the new store. The new store is an extension of the same supermarket chain and will have similar accounting and operations methods.

As per the given statistics, the annual earnings of the existing store since its opening five years ago is $5,00,000. Therefore, the calculation of net income by deducting the operating expenses, staff salary, maintenance costs, etc., from total earnings comes to b

As per the given statistics, the annual earnings of the existing store since its opening five years ago is $5,00,000. Therefore, the deductions of operating expenses, staff salary, maintenance costs, etc., worth $1,00,000 from total earnings, give a figure of $4,00,000. Therefore, the net income comes out to be $4,00,000, which the business uses for its valuation.

Next, the management of the supermarket chain calculates and estimates the returns for the investors of the existing store. It comes out to be 12%. Thus, this estimated figure will also help the investors and management know about the future return on investments (ROI) of the new store of the same supermarket chain opening at a similar location.

Limitations (Drawbacks)

After looking at the capitalization of earnings approach, let’s look at some of its limitations to understand the topic holistically.

  1. The differences in current and future accounting practices might change future earnings or net income. .
  2. Changes in the industry, like the advancement of technology or changes in customer preferences, might change a business’s cash flow. 
  3. For some businesses, cash flows might reveal the true potential of the core business operations. Thus, in such cases accounting for total earnings might not provide investors with a true picture.
  4. Suppose a company such as a start-up has a variable cash flow situation. In that case, present cash flow earnings might not be a true indication of similar future returns on investment.
  5. The investor might have higher risks if an investment has a higher discount rate. It is because the variations may arise in the future cash flows from the investment. Specifically, it is because the value of a dollar today is higher than its value tomorrow or in the future.
  6. An unforeseeable situation in the future also brings limitations to future earnings.
  7. A start-up enterprise in its initial stages will explore new methods of running its business processes. Such as accounting methods, operations, and hiring may be slower. Thus, changes in these methods may affect future earnings or returns.
  8. Similarly, future business accounting methods might not be strict enough or inaccurate. Thus, it reduces future expected returns or earnings. 

Frequently Asked Questions (FAQs)

1. What does capitalization of earnings mean?

It defines a process of estimating the returns on investment (ROI) from a business operation or project where the capital invested is huge. It enables the investors to know the future returns through a present earnings potential of a business and determine its valuation.

2. Why use capitalization of earnings method?

This method enables the investors to determine the business valuation based on its earnings and estimate future profits. Therefore, business analysts and investors need to identify returns on the capital invested as it helps ensure the sustainability of business operations and future cash flows.

3. How do you use capitalization of earnings techniques?

The calculation for capitalization rate includes the net operating cost divided by the asset’s cost to the investor or business. Further, the net income divided by the capitalization rate helps estimate the capitalization on earnings for the investor, revealing the investor’s true returns or income.

This has been a guide to Capitalization of Earnings and its Explanation. Here we discuss in detail how to determine it, its limitations & an Example. You may also find some useful articles here:

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