Top 10 Questions of Value: 1.What Is the Capitalization of Earnings Method?

In its simplest form, the Capitalization of Earnings Method provides an estimate of value of a company by converting the future income stream into value by dividing by a capitalization rate that incorporates a required rate of return for risk assumed by an investor along with a factor for future growth in the earnings stream being capitalized. This results in a value based on the present value of the future economic benefits that the willing buyer will receive through earnings, dividends, or cash flow. The capitalization method is based on the Gordon constant growth model which uses a single period proxy of future earnings to determine the present value of the asset. This method is usually employed when a company is expected to experience steady financial performance for the foreseeable future and when growth is expected to remain fairly constant. Extreme caution should be used when attempting to use this method, as applying a capitalization rate to the wrong “type” of earnings could spell disaster.

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