Capitalisation of earnings method
The term means a capitalisation method of valuation, which helps to estimate investment risks. Imagine, you’ve decided to buy a company but you don’t know whether it is profitable or not, and you need to check the company’s capitalisation of earnings. That’s where the capitalisation of earnings method comes in. It’s worth noting that this method is applicable only to stable companies, which have been on the market for several years already. Startups, merged companies or those with money damages can’t be valued with this method.
The company’s value is calculated using the following formula:
Value of a company = net profit/capitalisation rate
Let’s work it out, shall we?
Net profit is taken from the company’s financial reporting. Capitalisation rate is a bit more difficult and consists of two components: discount rate and percentage of the long-term growth rate of company’s profit. Looks like some kind of incomprehensible stuff, right? But we’ll get through it!
Future profit growth can be easily assessed using statistics of the previous years. The discount rate is more complicated but understandable. It consists of a stable percentage of income on bonds that give minimal risk (like government bonds) and the percentage of risks of the company itself, each of which is estimated from 1% to 5%. This is done by professional dudes, so don’t worry.
discount rate – the percentage of the long-term growth rate of company’s profit = capitalisation rate.
Let’s go through the procedure step by step using an example.
Imagine you want to buy a company that produces your favourite chocolate. It has been on the market since your childhood, shows the stable income and mostly everything is ready for you to buy it, aside one moment. You need to know the company’s capitalisation of earnings. And now let’s get the party started!
From the financial reporting, we learn about the income of the last three years. Let’s say it was £1,000,000. For instance, profit increased by 15%, 17%, 18% every year. We assume that on average every three years the profit will grow by 17%. So, 17% remember.
The next step is the discount rate, which is 22%.
- let’s take 3% for a stable percentage of income on bonds
- the percentage of risks of the company – 19%:
- owner is worth trusting – 1%
- the company sells only chocolate – 5%
- the company sells chocolate only to Belgium – 5%
- the business develops on its own money – 1%
- company is small – 5%
- company has a loyal base of customers – 2%
Remember about our 17%.
22% – 17% = 5%
5% is the capitalisation rate.
Now our capitalised value formula comes in:
1,000,000/0,05 = 20,000,000
So, the capitalisation of earnings of the chocolate company you liked is £20,000,000. Now it’s your turn to decide if you want to buy it or not.
Determining earnings capitalisation ratio
Sorry guys, but we have to give you another formula, stay strong!
(long-term commitments + short-term commitments) / own capital = earnings capitalisation ratio
In simple words, it’s the leverage of financial investments. It’s considered ideal when the amount of your credits is 50%, as well as your personal amount. So, a good earnings capitalisation ratio is 1%.
You need this ratio to assess the company’s solvency and risks if you want to become a business partner or buy the company. By the way, if you decide to invest using stocks apps for Android and IOS, download the Orca app to your smartphone (https://orca.app/ ). There you’ll find easy access to over 300 LSE stocks (stocks from NYSE and NASDAQ are coming soon!).
How to calculate business maintainable earnings
Okay, folks, the last thing here is maintainable earnings, which is predicted profit for 1, 2, 3 years. The formula here is kind of long, but we believe you’ll understand!
To calculate future maintainable profit firstly we need to know the Gross Profit, which is Revenue – Costs of Goods Sold
Secondly, we calculate the Net Profit before Taxation, which is operating, finance, and non-cash expenses.
Now the magic begins:
gross profit – net profit before taxation + interest, depreciation, abnormal or non-business expenses not related to the business – owners’ wages, non-business income, windfalls, other abnormal income = BUSINESS MAINTAINABLE EARNINGS
Let’s return to the chocolate. For instance, we know that cocoa beans grow in certain regions. If something happens in this region, the harvest may decline and chocolate prices will rise.
Moreover, chocolate is a snacky, so we have to take into consideration the economic environment. Unless economic shocks are expected, people will buy chocolate in the same amount.
Also don’t forget about trends, whether a healthy lifestyle tendency influences how much chocolate is bought or not.
As you see, there’re a lot of factors, but if a company has seen steady growth over the past three years, it can be assumed that this growth will continue.
We hope your brain hasn’t exploded with formulas, and you will read the key information you need to remember.
- Capitalisation of earnings method is a capitalisation method of valuation, which helps to estimate investment risks. You need to know the company’s capitalised earning approach if you want to buy or invest in the company.
- You need an earnings capitalisation ratio to assess the company’s solvency and risks if you want to become a business partner or buy the company.
- Maintainable earnings are predicted profit for 1, 2, 3 years.