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How Does the Capitalized Earnings Method Work?
Table of Content
- What is the Capitalized Earnings Valuation Method?
- How to Normalize Earnings for a Business?
- Determining the Capitalization Rate for Business Valuation
- How to Calculate the Enterprise Value?
- The 7 Steps of the Capitalized Earnings Valuation Method
- Capitalized Earnings Example
- Capitalized Earnings Valuation vs. Discounted Cash Flow (DCF) Valuation
- Capitalizing Earnings when calculating Terminal Value in DCF
- Capitalized Earnings Valuation Method is easy to apply but often lacks precision
The capitalized earnings method is one of the most commonly used business valuation methods due to its simplicity. The calculation is straightforward as we simply capitalize normalized profits. Compared to the Discounted Cash Flow (DCF) valuation method, which is also part of the income approach, the capitalized earnings valuation offers an easier and quicker way to estimate the net present value of a future income stream.
Due to its simplistic assumption of normalized profits to occur steadily into the future, the capitalized earnings method can become quickly subject to critique. Therefore, it is important to understand how this business valuation method exactly works, how the assumptions are derived, and when to use and not to use this valuation method that belongs to the income approach.
While this valuation method is widely used to value real estate properties (by capitalizing net operating income (NOI) or rental income with the capitalization rate of the property), the capitalized earnings valuation method is also used for estimating the value of a business. For the purpose of this article, we will examine how to use the capitalized earnings valuation method for valuing a business.
What is the Capitalized Earnings Valuation Method?
The capitalized earnings method is an income-oriented valuation technique that calculates the net present value of an infinite stream of normalized profits by capitalizing such annual income stream via a company’s discount rate, the Weighted Average Cost of Capital (WACC).
When valuing a business, the capitalized earnings valuation method determines a firm’s business value by calculating the company’s normalized earnings after tax. As these profits are assumed to be steady going forward, when using a company’s historic accounting records, the historic profit figures will have to be normalized. This means they have to be adjusted to exclude extraordinary effects.
Normalized earnings after tax, Net Operating Profit less adjusted Tax (NOPLAT) – which basically corresponds to EBIT less pro forma taxes – will then be capitalized by the company’s discount rate, the capitalization rate for businesses. Therefore, the formula for the CapitalizationEarnings Method is pretty simple and straightforward, we only need two basic elements: (1) NOPLAT and (2) capitalization rate.
Enterprise Value = NOPLAT / Discount Rate
Normalized Earnings are forward-looking and need to be estimated. Many times, a three-year average of a company’s EBIT adjusted for extraordinary items is used as a basis for such estimation which then is adjusted for pro forma taxes. Normalized earnings are assumed to remain the same forever. For this reason and due to the fact that adjustments can be highly subjective, the result of any capitalized earnings valuation can easily be challenged and argued as most likely views will differ on what normalized earnings will be.
This valuation approach is best suited to valuing a steady and profitable business. In case the business is growing, the denominator can deduct the company’s growth rate from the capitalization rate. Moreover, this valuation technique is frequently used to calculate the terminal value in a Present Net Value (NPV) analysis since, after five years of a forecast horizon, it usually is simpler to assume a steady level of normalized profits than keep estimating profits on an annual basis.
How to Normalize Earnings for a Business?
In business valuation, we should go beyond the available financial information to better understand which effects can be considered extraordinary. We should seek and conduct management interviews to understand the business operations and identify the items that require adjustment or normalization.
Normalized Earnings aim to exclude the effect of extraordinary income and expenses. Significant income and expenses unrelated to the core business operations can occur in a certain period which may drastically inflate or deflate the company’s profits. Therefore, normalized earnings offer a better view of the income potential of a company.
Normalized earnings information is also helpful when conducting trend line comparisons to understand how a company performs over time, and versus its competitors. Hence, investors can better interpret and compare companies based on the health of their core operations rather than the momentary boost or hit of a one-off event.
To normalize earnings, we need to calculate the normalized NOPLAT (Net Operating Profit less adjusted taxes), starting with determining the company’s EBIT (Earnings before interest and tax). Then, we factor in normalization items to determine a “normal” level of business operations. However, we wanted to compute the enterprise value, so interest expenses are not deducted, and proforma taxes are also accounted for and deducted from EBIT.
Listed below are some examples of items that should be excluded from normalized earnings but are not limited to:
- Gain on sale of equipment or asset disposal
- Gain from winning a lawsuit
- Extraordinary legal settlement
- Proceeds of Insurance Claim
- Restructuring Cost
- A temporary spike in raw materials costs (due to shortages brought by an extraordinary event such as war)
- COVID shutdowns or COVID related expenses
- Extraordinary depreciation and amortization (e.g. Goodwill write-down)
- One-time adjustment due to erroneous recording (i.e. capitalization of repairs and maintenance expenses)
- Excessive travel and entertainment expenses that are not necessary for business operations
- Personal travel expenses
- Incidental overnight expenses
- Late-night taxis
- Medical treatment abroad
- Reporting requirements
- Team off-sites and events
- Parties
- Gym membership or sports-related expenses
- Paid transportation cost
- Free food or beverages
- Donations or Charitable Contributions
- Shareholder’s bonuses
- Salary level adjustments in case a business does not pay market salaries, the company will have to adjust over time (this is the case for many owners -led SMES. Salaries to owners might not reflect market conditions)
- Vacation and travel expenses
- Automobiles
- Club membership
These are just a few examples of items for normalization. What they have in common is that they are one-off items. Most of the time, these effects are subjected to discussion if an effect should be adjusted or considered a normal part of business operations.
Determining the Capitalization Rate for Business Valuation
We can use the WACC (Weighted Average Cost of Capital) as the best proxy to use for determining the capitalization rates for business valuation. WACC estimates a firm’s opportunity cost of capital for its investors (the financing costs). Please refer to this article for more information on how to calculate WACC or use this WACC calculator to see how the calculation works exactly.
In case the company experiences (modest) growth, the capitalization rate could be reduced by the company’s growth rate. In that case capitalization rate = Discount Rate – Growth rate.
How to Calculate the Enterprise Value?
So how does this work then? Let’s say we have a NOPLAT of $100,000 and our WACC is 10%. So how much will be the value of the business?
Now our business valuation will look as follows;
Enterprise Value = $100,000 / 10% = $1,000,000
As you can see, we capitalized the Net Operating Profit less adjusted Taxes (NOPLAT) $100,000 by 10% and arrive at the business’ enterprise value of $ 1 Million.
The 7 Steps of the Capitalized Earnings Valuation Method
To determine the value of a business when using the capitalized earnings valuation method, we can work through the following 7 steps:
- Collect three years of historic Profit and Loss Data including all details which allow to calculate EBIT
- Analyze the historic financials for extraordinary one-off items and calculate how much these items affected the annual EBIT (the adjustments).
- Calculate the average of the three years normalized EBIT
- Deduct Pro-forma taxes from EBIT at the company’s expected Income Tax Rate to arrive at the normalized NOPLAT (which is basically EBIT less taxes)
- Define the capitalization rate by estimating the company’s Weighted Average Cost of Capital (WACC)
- Calculate Enterprise Value by dividing normalized NOPLAT by the capitalization rate
- Equity Value is calculated by adding back the beginning balance of cash to the enterprise value and then deducting the beginning balance of the financial debt.
It should be noted that the future tax rate will always be an estimate. In case there are tax losses carryforward available which can be used in the following years, those should be separately valued and added to the valuation results once used.
Capitalized Earnings Example
Assume that ABC Company is a business engaged in the manufacturing of fertilizers and pesticides. The board recently received an offer of takeover and requested a presentation of future earnings based on its three-year historical performance. Based on the capitalization rate calculation, the rate derived is 10%. The cash balance at the beginning of the period is $300,000, and the financial debt is $1,500,000. Several non-recurring and extraordinary events happened during the valuation date, which are summarized below. Now we like to calculate the enterprise value and equity value.
The below table shows three years of financial profit data and comments with respect to extraordinary items affecting these profits.
We now start with the reported EBIT and calculate the required adjustments to exclude the effect of such extraordinary items by reversing their impact.
This will then allow us to calculate three years of normalized NOPLAT. We then capitalize the three years’ average of NOPLAT by the company’s capitalization rate to arrive at the Enterprise Value. Last, we will need to deduct the debt and add the cash to get to the Equity Value.
As discussed earlier, the extraordinary income and expenses or non-recurring transactions need to be identified accordingly and excluded from calculating the normalized earnings. Hence, in this case, these one-time non-recurring and extraordinary costs are adjusted to arrive at the normalized earnings since they do not represent normal business operations.
Based on the capitalization earnings method equation, this $4,296,750 means that ABC Company would be worth this much if future earnings continued perpetually. While this method seems to be a whole lot simpler and easier to understand than the Discounted Cash Flow (DCF) valuation method, it’s only applicable if the business has a stable income stream over the years and does not factor in any growth rate. Therefore, this valuation method cannot be used for start-up businesses since it requires a historical stream of income.
Capitalized Earnings Valuation vs. Discounted Cash Flow (DCF) Valuation
As discussed earlier, the Capitalized Earnings Method falls under the income approach and is the quicker counterpart of a more complex valuation under the income approach, Discounted Cash Flow Valuation. You may refer to this article for more detailed information about the DCF valuation method. Meanwhile, let’s compare these two valuation methods to understand them better and eventually conclude the appropriate method for a specific investment.
In general, the DCF method provides greater flexibility in case cash flows, revenues, expenses, leverage, working capital, and capital expenditures change year by year. While the capitalized earnings valuation method is quick to apply for established and steady businesses, the DCF valuation method allows us to better capture the temporary profit and cash flow dynamics, especially when there are huge variations over the years. This also means, that the Capitalized Earnings Valuation method only works for businesses with stable cash flows and profits but not for Startups, special situations, or loss-making businesses. In those cases, better to use the DCF Valuation method.
Capitalizing Earnings when calculating Terminal Value in DCF
The capitalized earnings valuation method is frequently used to estimate the Terminal Value in a DCF valuation model. The formula is often adjusted to capture growth (by deducting the growth rate from the company’s discount rate for calculating the capitalization rate), so it becomes a Gordon Growth formula.
Terminal value captures the firm’s value beyond the projection period, and it is assumed that the business will grow at a constant rate into perpetuity. The future beyond the projection period is capitalized as the terminal value, and the method converges to single-period capitalization.
Assume the following fully adjusted cash flows of XY Company with a discount rate of 12%.
The projected annual net cash flows to be received at the end of each year and the corresponding present value factor is;
Year 1 of the projected cash flows is the year following the valuation date. Calculate the Enterprise Value and Terminal Value of XY Company.
No sustainable growth is assumed in this case. (Had we assumed a sustainable growth rate at two percent, our discount rate would have to be reduced by two percent to arrive at the appropriate capitalization rate.) The total enterprise value of XY Company is $1,009,301.
The terminal value often forms a large percentage of the DCF value, typically around 50% to 70%. The same is true in this case where 70% of the enterprise value came from the terminal value of $709,250. Therefore, it is important to understand this and, how the terminal value would greatly impact your valuation.
Capitalized Earnings Valuation Method is easy to apply but often lacks precision
The capitalization earnings method is a widely accepted valuation in practice. Like any other approach, this method has some advantages and disadvantages that one should be aware of to determine whether this method would support its intended purpose or if additional techniques are required to evaluate the business better and arrive at a reasonable conclusive value.
In general, capitalized earnings method is best used to evaluate real estate properties. But it is also particularly appropriate for valuing stable companies with a relatively stable historical earnings pattern which is expected to continue. On the other hand, this method is certainly not appropriate for startups due to a lack of a history of stable earnings and as they normally strong growth.
In valuing a business, it is necessary to identify the purpose and objective of the valuation to use the right business valuation approach. Ultimately, the approach relied upon would depend on the facts and circumstances of each situation.
The capitalization of earnings method is generally considered a short form of a discounted cash flow method, where a single representative earnings figure is capitalized rather than a stream of individual cash flows being discounted. This valuation technique tends to be more suitable for established businesses with stable earnings as this would be easier, quicker, and equally reliable.
For this reason, it is often used in calculating the terminal value in DCF valuation beyond the projection period in which it is assumed that the growth rate is constant. Though this method can be imprecise most of the time, it can offer a quick starting point in business valuation that can also be combined with a more appropriate valuation method.
To see how capitalized earnings valuation method applies in financial planning, here are ready-made industry-specific financial model templates that include valuation:
