Capitalization of Earnings

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Definition: Capitalization of Earnings

Capitalization of Earnings is an income based approach that is used to compute the present value of the business. This method can be used if the company’s future cash flows or profits can be reasonably predicted. The value of the company can be estimated by taking the economic benefits in terms of the future cash flows and discounting it at the capitalization rate, which is the rate of return based on an expected income. This can be illustrated as follows,

Capitalization Rate: Discount Rate – Long Term Growth Rate (d-g)

Present Value of Business:  Expected Earnings / (d-g)

For example, let us assume that a company X, growing at a rate of 5% per annum, is expected to earn a profit of Rs. 1 million. At the given level of risk, the annual rate of return is 19%. The present value of the business for the purchaser can be computed as follows,

Present Value = Rs. [1 / (.19-.05)] million

                            = Rs. 7.14 million

Hence, this concludes the definition of Capitalization of Earnings along with its overview.

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