The Capitalization of Earnings method is an income-based valuation approach that estimates a company’s value based on its expected future earnings. Instead of projecting detailed cash flows year by year, this method takes a representative level of earnings and converts it into a present value by applying a capitalization rate. The idea is straightforward: the more sustainable earnings a company can generate, the higher its value today.
Within the broader income approach, the Capitalization of Earnings method is often seen as a simpler alternative to the Discounted Cash Flow (DCF) analysis. While DCF requires detailed forecasts and discounting of future cash flows, the capitalization method works best when a company has relatively stable profits or cash flows. This makes it a practical tool for valuing businesses with predictable earnings, though less suitable for firms facing volatile or uncertain growth.
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:
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:
For medium-sized and large companies, analysts typically use EBIT or EBITDA.
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.
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.
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.
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.
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:
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.
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.
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.
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.
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.
Key factors when valuing a company using the Capitalization of Earnings Method include:
Different metrics are used in the Capitalization of Earnings Method depending on the business model:
Additional metrics include:
To normalize earnings, review past financial statements and remove anything that is one-time, unusual, or non-recurring. Examples:
The goal is to get a realistic view of sustainable operating profits.
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:
👉 In our Case Library, you'll find additional exercises on the Capitalization of Earnings Method and Discounted Cash Flow (DCF) valuation.
The Capitalization of Earnings method is a simple yet effective valuation tool best suited for companies with stable, predictable earnings.
It is particularly useful when a company’s future financial performance is expected to mirror its past, such as in established firms with reliable cash flow. For startups, volatile business models, or companies undergoing major changes, this method is less appropriate, as it doesn’t allow for a detailed breakdown of individual cash flows or distinct growth phases.
