The capitalization rate of a business is determined by dividing the company's current earnings by the monetary value of the company. This gives you a percentage. For example, if you determine a company you buy for $1 million makes $100,000 per year, it has a capitalization rate of 100,000/1,000,000 or 10 percent. However, when you talk of capitalizing earnings, you are referring to dividing the future and present earnings by the capitalization rate. The formula for capitalization earnings is: future earnings/capitalization rate. This is one way of valuing a business.
One disadvantage of basing your valuation of a company on future earnings is that the projected future earnings may wrong. Estimates may not be accurate. Unforeseen circumstances could cause earnings to be much less than anticipated. If you purchase such a business, you could not get the income from it that you want.
Current Capitalization Rate Errors
Because capitalization of future earnings depends on the current capitalization rate for its formula, you must make sure that rate is reliable. Sometimes business owners use the most recent year's earnings. Ask for an average over the past three to five years, and you will mitigate the effect of unusual spikes in any given year.
Compare Capitalization to a Market Valuation
Capitalization of future earnings can give you a business valuation that's significantly different from the market valuation. Market valuation reflects the probable value of a company based on what similar companies are selling for. Capitalization of earnings can set a business price that is out of line with market prices.
Capitalization vs. Cost Approach
A cost approach to business valuation determines the current value of assets vs. liabilities. Taking liabilities into account helps establish a realistic appraisal. Capitalization of future earnings does not take liabilities into account. In short, those future earnings may come at a price because of outstanding debt. Borrowing expenses could eat into earnings.