What do you understand by capitalization of earnings How is the value of a firm ascertained with the help of its earnings Explain with an example?

'Capitalization Of Earnings'

A method of determining the value of an organization by calculating the net present value (NPV) of expected future profits or cash flows. The capitalization of earnings estimate is done by taking the entity's future earnings and dividing them by the capitalization rate (cap rate). This will take into account the risk that earnings will stop or be lower than the estimate.

Where:

d = discount rate

g = growth rate

This is an income-valuation approach that determines the value of a business by looking at the current benefit of realizing a cash flow now, rather than in the future. The capitalization of earnings is particularly useful when the future earnings can be predicted easily and accurately.

For example, if a company had a business that made $1.2 million last year and that was expected to grow at a 4% rate (plus a 3.25% inflation rate), the annual rate of return needed by a purchaser given the level of risk would be 26%. Expected value using the capitalization of earnings method would be $6.4 million, calculated as:

-$1,200,000/ (0.26 - (.04+.0325))

-$1,200,000/0.1875

-$6.4 million