When to use the capitalized earnings valuation method

Capitalized earnings valuation method pops up all the time in appraisals of just about any income producing asset – commercial real estate, businesses, or any other valuable asset.

What makes the capitalized earnings method so popular?

So what makes this valuation method so popular? In short, simplicity and wide acceptance by the valuation professionals, courts, business people, and investors. Who hasn’t heard of the cap rate used to figure out the value of real estate?

In formal terms, capitalized earnings acts as a short hand for the discounted cash flow method. In fact, the two valuations produce identical results as long as the earnings growth rate remains constant. Capitalized earnings should also offer you a decent choice if your earnings growth appear stable so that you can estimate the average growth rate reliably.

Situations where you should consider other valuation methods

So far, so good. But you may wonder: in which situations should you use alternative valuation methods to get accurate results?

Business appraisers have a general rule here. Whenever your business earnings vary greatly or unpredictably year over year, capitalized earnings method may produce misleading results.

Take note of one classical scenario. Let’s say the income stream from the asset being valued stops at some future time. Suppose the business owners plan to wind up and dissolve the company some years in the future. You can forecast an income stream and then estimate the residual value of business assets when the company closes its doors.

In this scenario you’d best resort to the discounted cash flow valuation. You can use your finite-time cash flow forecast and residual value to calculate the present value of the business, or what it is worth today.

This will not work if you stick with the capitalized earnings valuation method. The implied assumption made here is that your earnings will continue indefinitely, growing at the constant rate!

But here you expect your business earnings to stop abruptly and dispose of the residual assets. The capitalized earnings method cannot handle such situations well.

Cash cows versus high fliers – choose carefully

So there you have it. If the business you value is a cash cow expected to chug along happily, go ahead and use the capitalized earnings technique. If, on the other hand, you anticipate significant change in earnings down the road or have limited visibility into the business’s prospects, you should stick with the discounted cash flow valuation.

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