Calculate business value, earnings, or capitalization rate with the capitalization of earnings method by entering any two values to find the missing one.
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Capitalization of Earnings Method Formula
The capitalization of earnings method estimates business value by converting a stable earnings amount into value using a capitalization rate. The calculator can solve for business value, earnings, or capitalization rate when you enter the other two values.
- Value = estimated value of the business in dollars
- Earnings = normalized annual earnings of the business in dollars
- Capitalization Rate = required rate of return or risk-adjusted cap rate, entered as a decimal
To solve for earnings, the formula is rearranged:
To solve for the capitalization rate, the formula is rearranged:
- Calculate value: enter earnings and the capitalization rate. The result is the estimated business value.
- Calculate earnings: enter business value and capitalization rate. The result is the earnings level implied by those inputs.
- Calculate capitalization rate: enter earnings and business value. The result is the cap rate implied by the valuation.
Capitalization Rate Reference Table
Capitalization rates are entered as decimals. For example, 20% is entered as 0.20.
| Capitalization Rate | Decimal Entry | Implied Multiple | General Interpretation |
|---|---|---|---|
| 10% | 0.10 | 10.0x earnings | Lower perceived risk or stronger stability |
| 15% | 0.15 | 6.67x earnings | Moderate risk and moderate stability |
| 20% | 0.20 | 5.0x earnings | Higher risk or less predictable earnings |
| 25% | 0.25 | 4.0x earnings | Higher uncertainty or smaller business risk |
Earnings and Value Relationship
The same earnings produce a higher valuation when the capitalization rate is lower, and a lower valuation when the capitalization rate is higher.
| Annual Earnings | Value at 10% | Value at 15% | Value at 20% |
|---|---|---|---|
| $100,000 | $1,000,000 | $666,666.67 | $500,000 |
| $250,000 | $2,500,000 | $1,666,666.67 | $1,250,000 |
| $500,000 | $5,000,000 | $3,333,333.33 | $2,500,000 |
Example
Example 1: Calculate business value
You have normalized annual earnings of $300,000 and a capitalization rate of 0.15.
The estimated business value is $2,000,000.
Example 2: Calculate capitalization rate
A business is valued at $1,250,000 and has annual earnings of $250,000.
The implied capitalization rate is 0.20, or 20%.
FAQ
What earnings should you use in the capitalization of earnings method?
You should use normalized annual earnings that reflect the business’s expected ongoing performance. This often means adjusting for unusual, one-time, or non-operating items. The method is most useful when earnings are reasonably stable.
How do you enter the capitalization rate?
Enter the capitalization rate as a decimal. For example, enter 12% as 0.12, 18% as 0.18, and 25% as 0.25. Do not enter 12 for 12%, because that would mean 1200%.
What does a higher capitalization rate do to business value?
A higher capitalization rate lowers the estimated value because it reflects a higher required return or higher perceived risk. For the same earnings, a business valued at a 20% cap rate will be worth less than one valued at a 10% cap rate.
