Earnings Capitalization Model
The earnings capitalization model values the company based upon the company earnings. To determine normalized earnings, you calculate a weighted average of earnings over a period of years. The earnings reported on financial statements or tax returns are normalized through several steps. These modifications include the deduction of extraordinary gains or additions for losses, large employee salaries. Earnings are weighted based upon when earned. The most recent earnings are weighted more heavily than older amounts. The weighting value depends on the stage of life of the company and the company’s growth over the time period. A mature company will have more consistent earnings and will be weighted less than startup ventures with rapidly changing annual earnings.
The earnings are assumed to continue in perpetuity. The business is valued by dividing the normalized earnings by a capitalization factor. The capitalization factor is generally expressed as a percentage of the earnings. In the case of growing businesses (such as startups), the firm is assumed to have a constant growth rate. The growth rate is then subtracted from the discount rate to obtain a capitalization rate. This is an adaptation of the Gordon model (discussed further below). The discount rate is determined by identifying the value that the marketplace gives to comparable publicly traded companies or through a process known as the “buildup method.”
Earnings Capitalization Model (and Buildup Method)
The earnings capitalization model faces the difficulty of weighting the cash flows attributable to the business and identifying an adequate discount rate (or cap rate) for the projected cash flows. While the concept of weighting more recent cash flows more heavily is a sound practice, there is not set rule on the weight attributable to a given cash flow. Further, the capitalization rate is difficult to determine is startup ventures, due to the early stage of growth.