The capital earnings valuation is one of the approaches (the other one is the Discounted Cash Flow Valuation) of the income approach method. It is computed by dividing the economic benefit of the business by the capitalization rate. And most companies use the earnings as the expected financial benefit. The capitalization rate depends on the industry and the specific risk profile of a company in light of market alternatives.
How Does it Work?
There are two main components in computing for the capitalized earnings valuation: Earnings and Capitalization Rate.
- Using the earnings projection as the basis for analysis can give erroneous results if the earnings are not as projected. Unfavorable circumstances can also happen that might make a difference to the expected outcome, which means lower income for the business.
- Capitalization Rate. The computed capitalization rate must genuinely reflect the business condition. Using average earnings as the basis in computing for the rate would mitigate the unusual changes that might occur.
When to Use?
Capitalized earnings valuation considers a normalized income stream in the calculation evaluation. This method is used by companies that have relatively stable margins and growth, which are mature and established businesses. As the company is commonly valued based on the current and future income cash streams, this method is quite the right approach preferred by the investors.
- Real Estate. It works well, e.g., for rented properties in real estate.
- Terminal Value. It is widely used to estimate terminal value since you only have to identify the expected income of the last projected year and the exit capitalization rate.
- The courts usually utilized the capitalized earnings for litigation since it is easy to understand and applied.
- Tax Valuation. Since the formula for capitalized earnings is straightforward, tax computed with ease based on the net income before tax.
Capitalized Earnings Valuation vs. Other Valuation Methods
Let us compare the capitalized earnings to other valuation methods: Discounted Cash Flow Approach, Market Approach, and Asset Valuation.
Capitalized Earnings Valuation vs. the Discounted Cash Flow (DCF) Approach
DCF: Uses Free Cash Flows as the basis for valuation
- Deducts CAPEX, NWC investments
- Uses several years to forecast, typically five years
- Complicated to explain
Capitalized Earnings: Uses earnings as the basis for valuation
- You can manipulate depreciation
- Only considers one normalized year
- Easier to explain
Capital Earnings Valuation vs. Market Approach
The latter considers the value investors willing to pay for a related company. The capitalization valuation might be different from what the sellers are willing to pay for the business.
Capital Earnings Valuation vs. Asset Valuation
Capital earnings valuation does not consider the assets and liabilities of the company. Capital-intensive companies such as real estate and manufacturing may have a disadvantage since the value of their assets is not admitted into the valuation. Companies that have invested heavily in their physical assets may tend to have lower estimates compared to businesses with fewer assets to operate. Also, not being able to account for the company’s liabilities in the valuation would mean that the corresponding result was not able to allocate its earnings in its debt repayment, which would be crucial if the valued company has a sizable amount of debt.
Conclusion: Advantages and Disadvantages of Capitalized Earnings Valuation
After evaluating how capitalized earnings works, its use, and comparisons with other business valuations methods, we are now down to the pros and cons of capitalized earnings. Let’s discuss these below.
Pros:
- Quick to do
- Simple to use
- Easy to understand
- Not complicated to explain
- Takes into account the future expected earnings which most investors look at
Cons:
- The capital earnings method can be disadvantageous if the business is only operating for a few years since there are not enough data points
- The formula can only give valuable results if there is enough information to use
- Does not take into account CAPEX
- Does not take into account Net Working Capital Investments
Though disadvantages are highlighted in this article, capital earnings valuation is one of the most used tools for business valuation. It is just a presentation of risks that you might encounter if you opt to use the capital earnings valuation. Also, a diligent and smart investor would not just rely on one valuation approach in scrutinizing the company value, instead of looking at the results of different valuation methods. Please refer to the various financial model templates of eFinancialModels to learn more about the different ways in business valuation.
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