Capitalization of earnings definition
/What is the Capitalization of Earnings?
The capitalization of earnings is used to value a business by deriving the net present value of its projected future earnings. The concept can also be applied to individual subsidiaries, product lines, products, and work centers to determine their value for further investment purposes.
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Limitations of the Capitalization of Earnings Method
There are several issues to be aware of when using the capitalization of earnings method. They are as follows:
Uses the wrong basis. Cash flows should be discounted rather than reported earnings, since earnings information may not be indicative of the core earnings potential of a business.
Subject to variability. Consider the variability of projected cash flows. If the entity has had a history of variable cash flows, consider reducing the amount of future cash flows included in a capitalization of earnings calculation, or use a higher discount rate.
Difficult with little historical information. There may not be enough of a prior cash flow history to create a valid set of expected future cash flows. When there is little historical information available, the certainty of cash flow projections is reduced - perhaps substantially.
Subject to excessive optimism. When valuation is based on future earnings, this creates an opening for an overly optimistic person to drive up future estimates, resulting in a greatly inflated valuation.