The case for capitalization of earnings method in business valuations
Capitalization of earnings is a method of company valuations under the Income approach. Unlike a more widely used Discounted cash flow analysis (DCF) method, which forecasts cashflows/Earnings over multiple future periods before a terminal value is determined, the Capitalization of earnings method relies on a single period cashflow/Earnings forecast to arrive at a valuation for the subject. It assumes that the subject company will grow at a fixed growth rate into perpetuity.
The capitalization of earnings method is simpler to apply than a DCF analysis. It is especially useful to value established matured companies where it is fair enough to assume a stable growth rate in cashflows/earnings forever.
In this blog, we will discuss how to value a company using the Capitalization of earnings method, required inputs for the valuation, essential factors to consider while carrying out a valuation based on capitalized earnings, its advantages, and limitations.
How to carry out valuation using the Capitalization of Earnings method
At the initiation, it is critical to decide whether the task is to value the entire firm (Equity plus Debt) or just the Equity in a business, as inputs to the valuation process differ based on it (as we will see going ahead). The following are the inputs required for valuation:
Cashflow/Earnings: The valuator may choose to use Operating income (EBIT) or Free cash flow to the firm (FCFF) if he wants to value the entire firm, or he may use Net income or Free cashflow to Equity (FCFE) if the requirement is to value just the Equity in the business. Apart from these, in some cases, it might be more relevant to use EBITDA or after-tax operating income. Whether an income measure should be chosen or a cash flow measure depends on the quality of financial reports, the status of the respective metrics, etc.
Growth rate (G): The capitalization of Earnings method assumes a fixed perpetual growth rate in Cashflows/Earnings. The perpetual growth rate for a company must not be higher than the growth of the country’s GDP.
Discount rate: Another important input in Capitalized earnings method is the rate of discounting. The discount rate should reflect the underlying risk in the business, the opportunity cost of capital and the nature of the cashflow/Earnings metric used. Riskier companies would have higher discount rates than safer companies. If the financial metric used is a firm-wide metric (EBIT, EBITDA, or FCFF), then the discount rate must be a weighted average cost of capital (WACC); if an equity-wide metrics such as Net income or FCFE is used, the discount rate would be Cost of equity (ke).
Capitalization rate (WACC – G): Cap rate is the difference between the Discount rate and growth rate.
Illustration: Let’s take an example to understand the valuation process better.
Consider a hypothetical company XYZ Inc. which generated an FCFF of $100 million in the current year. And the company is forecasted to grow at a steady growth rate of 3%. WACC for the company is, say,9%. So, the value that we will get using the capitalization of earnings method will be computed as follows:
Value of Firm = FCFF x (1+G) / WACC – G
= 100 x (1+3%) / 9% – 3%
= $1716.66 million
To compute equity value, we need to subtract the value of debt from the Firm value. If XYZ Inc. has outstanding debt of $900 million, then the value of Equity will be $1716.66 – $900 = $816.66 million.
The following factors should be kept in mind while carrying out valuations using the Capitalization of Earnings method:
- It assumes constant growth into perpetuity; therefore, it should not be used for young, high-growth companies with varying growth rates over time.
- Constant perpetual growth rate should not be more than the growth rate of the overall economy; otherwise, in perpetuity, the subject company will become more valuable than the overall economy, which is unrealistic.
- The discount rate should reflect the nature of the cash flow/Earning metric used. If cash flow is a firm-wide metric such as EBIT, then WACC should be applied as the discount rate; if growth is in nominal terms, then the discount rate should also be in nominal terms, etc.
- If a firm-wide earnings/cashflow metric is used, the value thus arrived would also be firm value; debt should be subtracted from it to arrive at equity value.
Advantages and limitations
Advantages: The most significant merit of the Capitalization of Earnings method is that it is much easier to use than a DCF or CCA technique. And if it is used considering the factors mentioned above and its limitations, then it works as good as any other valuation technique. Due to its simplicity, it is quite often used for litigation valuation as it is much easier to explain in a court of law than a DCF or other techniques.
Limitations: Although the Capitalization of earnings method has a sound theoretical base, it is designed only to be used in very restrictive situations; a DCF usually provides much higher flexibility to deal with different valuation challenges. Capitalization of earnings can be used only for well-established matured companies, which are expected to grow at a constant growth rate forever. So, it cannot be used to value start-ups, companies with negative earnings, technology companies, companies where industry dynamics change frequently, etc. Also, it relies heavily on accounting records, especially when an earnings metric (EBIT or EBITDA, etc.) is used; changes in accounting practices and classification criteria may alter valuation significantly.
The capitalization of earnings method could be an excellent alternative to a DCF analysis, especially for well-established matured companies, as it is simpler to use, easier to understand, and requires fewer inputs than DCF. But in today’s competitive and dynamic world where things are changing quite fast, and evolving technologies are disrupting old business practices, is it justifiable to assume a fixed growth rate into perpetuity, or should a more profound analysis such as DCF be used instead for business valuations?