Capitalization Of Earnings

Earnings came in a blip. That huge Ship-in-a-Bottle project was completed and, in this quarter, your company earned $18 million. But the number is kind of misleading, because your next huge Ship-in-a-Bottle won't be finished for a year-and-a-half. So rather than just have $18 million to the good, followed by 6 quarters of "to the bad," you capitalize your earnings and recognize them "ratably" over the next 6 quarters as $3 million a quarter.

It’s easy to look at the present value of a business: just look at their current cash flow, earnings, and other presently-available info. But what about the future? It’s the future we care about, because decisions we make now will have consequences in the future. If only there was a way to figure out how much a company is worth now and in the future…

Okay, we know, you’ve been through this wringer before, so you know what’s coming next. Yes, there is a way to determine the value of a company now and in the future. It’s called the capitalization of earnings.

The capitalization of earnings uses the net present value (NPV) of expected future profits or cash flow. This helps investors weigh the benefits and costs (potential risk) before they decide whether or not to put their bucks towards a company.

More specifically, the capitalization of earnings is when you divide the company’s future earnings by the “cap rate,” which is net operating income divided by purchase price. The downside to this is that, of course, we still don’t know the future for sure. Estimated future earnings may be inaccurate, or something like a stock market crash could happen. You never know.