The Capitalization of Earnings method is part of the income-based approaches used in business valuation. Alongside the Market Approach and the Asset Approach, income-based methods represent one of the three primary approaches to valuing a company. Within the income-based category, the Capitalization of Earnings method and the Discounted Cash Flow (DCF) method are among the most commonly used.
The Capitalization of Earnings method values a company based on its expected future earnings (income-oriented valuation). At its core, it seeks to answer the question: “How much is this company worth today, based on the money it is expected to generate in the future?”
This approach is based on the assumption that a company’s value is directly tied to its ability to generate stable profits or cash flows over time.
How the Capitalization of Earnings Method Works
Essentially, this valuation technique calculates the present value of a business by dividing its expected earnings by a capitalization rate. So, the formula for the capitalization of earnings method is:
Expected Normalized Earnings
The expected earnings component of the formula represents the business’s projected annual earnings. The figure is often normalized by adjusting for extraordinary items, non-operating income, or one-time expenses.
In an income statement, results are determined step by step, from the operating income down to the final net profit. In the Capitalization of Earnings method, different profit metrics may be used depending on the context:
1. EBIT or EBITDA
For medium-sized and large companies, analysts typically use EBIT or EBITDA.
- EBIT (Earnings Before Interest and Taxes) = profit before interest and taxes.
- EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) = profit before interest, taxes, and depreciation/amortization.
These figures reflect how profitable the core business is, regardless of financing or depreciation methods, and are well-suited for comparing different companies.
EBIT is selected when investments and depreciation realistically impact future earnings potential, whereas EBITDA is used to exclude these effects and focus on operating performance—either in isolation or for benchmarking.
2. Adjusted Net Income
In larger companies, analysts often start with net income, but adjust it for exceptional or one-time effects such as restructuring costs or litigation expenses. The result is a clearer picture of the company’s recurring earnings.
3. Seller’s Discretionary Earnings (SDE)
For small, owner-managed businesses, SDE is often used. This metric adjusts the reported profit by adding back the owner’s salary, benefits, personal expenses, and any one-time or non-operational items. SDE reflects how much money a new owner could realistically take out of the business.
4. Net Income
Net income is the "bottom line." It shows the profit remaining after all costs have been deducted, from wages and materials to interest, taxes, and depreciation. It's especially relevant for owners, as it represents the final annual profit.
Since the Capitalization of Earnings method heavily relies on profit trends, it is best suited for businesses with relatively stable and predictable earnings. It is less appropriate for companies with highly volatile financials.
In practice, analysts often rely on historical averages, for example, the mean of the past three to five years, or use forecasts. Sometimes, both are combined to smooth out anomalies and present the most realistic earnings picture possible.
Capitalization Rate (Cap Rate)
The capitalization rate, often abbreviated as "Cap Rate," represents the expected return on an investment while factoring in the associated risk.
Formula:
At its core, the Cap Rate answers the question: “What return do investors demand for the risk they are taking, and how does expected growth affect this?”
The Cap Rate is calculated in two steps:
1. Determining the Expected Return
The starting point is the risk-free interest rate, i.e., the return achievable without risk (e.g., through government bonds). A risk premium is then added to reflect the company’s specific uncertainties—such as market or industry risks, dependency on a few customers, or the stability of earnings.
The size of this premium depends on several factors. A stable sector like utilities or grocery retail is seen as less risky than cyclical sectors like automotive or luxury goods. Company size also plays a role: smaller firms are typically more vulnerable to crises and thus receive a higher premium.
Other important factors include financial structure. Companies with high debt or heavy reliance on a few customers or suppliers are considered riskier. Additionally, the macroeconomic environment influences the premium, as investors generally demand higher returns during uncertain times.
In practice, these premiums usually range between 3 to 5 percentage points for established, low-risk companies. For smaller or more volatile businesses, the risk premium may range from 6 to 10 percentage points or more. This approach tailors the expected return to reflect the individual risk profile of the business.
2. Subtracting the Growth Rate from the Expected Return
From the expected return, the long-term growth rate of profits is subtracted. The result is the capitalization rate (Cap Rate). The logic behind this: a company that can grow its profits year after year is worth more today than a company with flat earnings. Future growth effectively reduces the required return, since investors will receive part of their return through increasing profits.
Example:
Let’s assume the risk-free interest rate is 3%. A risk premium of 5% is applied for company-specific risks, resulting in an expected return of 8%. If we subtract an expected profit growth rate of 2%, we get a Cap Rate of 6%.
Typical Cap Rates for small businesses range between 20% and 25%. The Cap Rate brings together risk, return expectations, and growth in a single metric. In the Capitalization of Earnings method, it is the key factor that determines how expected profits are translated into today’s business value.
This method combines two core elements: annual earnings and the capitalization rate, which consolidates risk and growth into one figure. Dividing the expected earnings by the Cap Rate yields the current business value.
That makes the Capitalization of Earnings method particularly suitable for companies with stable, predictable earnings. It delivers a clear and traceable result and highlights how closely a company's value is tied to its ability to consistently generate profits.
Common Interview Questions on the Capitalization of Earnings Method
The Capitalization-of-Earnings Method is a common topic in finance interviews – a simple but effective way for interviewers to test your valuation know-how.
1. Explain the Capitalization of Earnings Method.
The Capitalization of Earnings method is a business valuation approach based on expected future earnings. At its core, the method estimates today’s company value by dividing normalized annual earnings by a capitalization rate. The formula is: Company Value = Normalized Annual Earnings ÷ Capitalization Rate
The capitalization rate reflects the return investors expect, calculated as the risk-free interest rate plus a risk premium for company-specific factors, minus the expected growth rate.
The choice of earnings metric depends on the context. For small, owner-operated businesses, SDE (Seller’s Discretionary Earnings) is often used. For medium and large companies, EBIT, EBITDA, or Adjusted Net Income (if extraordinary effects need to be removed) are more common.
This method is best suited for companies with stable and predictable earnings, as it does not require a detailed analysis of cash flows or phases, unlike the DCF method. For startups or highly volatile business models, it is less meaningful.
2. What are the limitations of the Capitalization of Earnings Method?
The Capitalization of Earnings Method method works best for businesses in stable, predictable markets. It is less suitable for startups, volatile sectors, or fast-growing companies, where future earnings are difficult to forecast.
A key challenge is that the method is highly sensitive to inaccuracies in earnings estimates or the capitalization rate. Even small deviations can significantly change the valuation.
Additionally, it does not consider asset values or the timing of cash flows, and it may oversimplify complex business models by reducing them to a single metric.
3. What matters when valuing a company using the Capitalization of Earnings Method?
Key factors when valuing a company using the Capitalization of Earnings Method include:
- How stable and sustainable are the earnings?
- Were extraordinary items properly adjusted (normalized)?
- What is a realistic long-term growth rate?
- How risky is the business model?
- What is the market and industry context?
- Are there comparable transactions or Cap Rates in similar markets?
4. What types of earnings metrics are used in the Capitalization of Earnings Method?
Different metrics are used in the Capitalization of Earnings Method depending on the business model:
- EBIT or EBITDA are most common, as they show how much the company earns from core operations, regardless of financing, taxes, or depreciation.
- In real estate, Net Operating Income (NOI) is used, representing rental income minus operating expenses.
Additional metrics include:
- Adjusted Net Income, used when extraordinary or non-operating items need to be removed to reflect recurring earnings.
- Seller’s Discretionary Earnings (SDE), often used for small owner-operated businesses, includes owner’s salary and personal expenses to reflect the true available cash flow for a buyer.
5. How do you adjust earnings for one-time effects?
To normalize earnings, review past financial statements and remove anything that is one-time, unusual, or non-recurring. Examples:
- Add or subtract one-time legal costs or gains
- Remove gains or losses from asset sales
- Add back exceptional repairs or purchases
- Add owner-related expenses, like excessive salaries or personal expenditures
The goal is to get a realistic view of sustainable operating profits.
6. How does the Capitalization of Earnings Method differ from the Discounted Cash Flow (DCF) Method?
The Capitalization of Earnings method is simpler in its assumptions: it uses a single annual value divided by a Cap Rate. This works well for mature businesses with steady earnings and assumes stable future growth.
The DCF method, on the other hand, looks at multiple future years—typically 5 to 10—and discounts each future cash flow back to present value. It better captures fluctuating profits, changing risk, or growth phases.
In short:
- DCF is more flexible and accurate, but data-intensive
- Capitalization of Earnings is simpler and more practical, but only meaningful when the business model is stable
👉 In our Case Library, you'll find additional exercises on the Capitalization of Earnings Method and Discounted Cash Flow (DCF) valuation.