by Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset, rather than being expensed in the period the cost was originally incurred. In finance, capitalization refers to the cost of capital in the form of a corporation’s stock, long-term debt, and retained earnings. In addition, market capitalization refers to the number of outstanding shares multiplied by the share price.
Capitalization has two meanings in accounting and finance. In accounting, capitalization is an accounting rule used to recognize a cash outlay as an asset on the balance sheet, rather than an expense on the income statement. In finance, capitalization is a quantitative assessment of a firm’s capital structure.
Capitalization in Finance
Another aspect of capitalization refers to the company’s capital structure. Capitalization can refer to the book value cost of capital, which is the sum of a company’s long-term debt, stock, and retained earnings. The alternative to the book value is the market value. The market value cost of capital depends on the price of the company’s stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding in the market.
If the total number of shares outstanding is 1 billion and the stock is currently priced at $10, the market capitalization is $10 billion. Companies with a high market capitalization are referred to as large caps (more than $10 billion); companies with medium market capitalization are referred to as mid caps ($2 – $10 billion); and companies with small capitalization are referred to as small caps ($300 million – $2 billion).
It is possible to be overcapitalized or undercapitalized. Overcapitalization occurs when earnings are not enough to cover the cost of capital, such as interest payments to bondholders or dividend payments to shareholders. Undercapitalization occurs when there’s no need for outside capital because profits are high and earnings were underestimated.
Capitalization of earnings
Capitalization of earnings is a method of determining the value of an organization by calculating the worth of its anticipated profits based on current earnings and expected future performance. This method is accomplished by finding the net present value (NPV) of expected future profits or cash flows, and dividing them by the capitalization rate (cap rate). This is an income-valuation approach that determines the value of a business by looking at the current cash flow, the annual rate of return, and the expected value of the business.
The capitalized earnings method consists of calculating the value of a company by discounting future profits with a capitalization rate adjusted to the determining date for the valuation.
In the context of the capitalized earnings method, a company is considered as an investment. Attention is therefore focused solely on the future profits that the company will make, on the associated risks or on earnings projections. Operating assets are seen only as a way of making profits and no specific value is allocated to these.
To calculate capitalized earnings, the company’s profits are estimated for the following two to five years from the valuation date. It is important to point out that this refers to adjusted profits. Extraordinary and non-operating income and expenses, along with salaries not conforming to the market, must be adjusted. Adjusted operating profits are discounted using a capitalization rate corresponding to an earnings projection adapted to the risk of this specific company. If the company has assets not essential to operation (e.g. real estate outside the company or surplus liquidities), these will be calculated separately, then added to the capitalized earnings calculated.
Calculating the capitalization of earnings helps investors determine the potential risks and return of purchasing a company. However, the results of this calculation must be understood in light of the limitations of this method. It requires research and data about the business, which in turn, depending on the nature of the business, may require generalizations and assumptions along the way. The more structured the business is, and the more rigor applied to its accounting practices, the less impact any assumptions and generalizations my have.
Determining a Capitalization Rate
Determining a capitalization rate for a business involves significant research and knowledge of the type of business and industry. Typically, rates used for small businesses are 20% to 25%, which is the return on investment (ROI) buyers typically look for when deciding which company to purchase.
Because the ROI does not include a salary for the new owner, that amount must be separate from the ROI calculation. For example, a small business bringing in $500,000 annually and paying its owner a fair market value (FMV) of $200,000 annually uses $300,000 in income for valuation purposes.
When all variables are known, calculating the capitalization rate is achieved with a simple formula, operating income/purchase price. First, the annual gross income of the investment must be determined. Then, its operating expenses must be deducted to identify the net operating income. The net operating income is then divided by the investment’s/property’s purchase price to identify the capitalization rate.
Drawbacks of Capitalization of Earnings
Evaluating a company based on future earnings has disadvantages. First, the method in which future earnings are projected may be inaccurate, resulting in less than expected yields. Extraordinary events can occur, compromising earnings and therefore affecting the investment’s valuation. Also, a startup that has been in business for one or two years may lack sufficient data for determining an accurate valuation of the business.
Because the capitalization rate should reflect the buyer’s risk tolerance, market characteristics, and the company’s expected growth factor, the buyer needs to know the acceptable risks and the desired ROI. For example, if a buyer is unaware of a targeted rate, he may pay too much for a company or pass on a more suitable investment.
Capitalized earnings = Long-term operating profit * 100 / Capitalization Rate
The capitalization rate is calculated as follows, remembering that the corresponding figures may vary depending on the company’s size, sector and individual circumstances.
- Risk-free interest rate
- Market risk premium
- Rate for small companies
- Rate of non-liquidity
- Rate for risk specific to the company: on a case-by-case basis
