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.
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finance a la shmoop- what is compounding value or compounding interest? ah the
power of compounding. it makes trees stronger pollution more feral and the
rich well richer. how so well let's start with compounds kissing
cousin with six toes, arithmetic compounding. right so the first was [feet with six toes pictured]
really geometric compounding now we're talking about arithmetic compounding. if
you invest a thousand bucks in a ten-year bond that pays 6% of a year in
interest, the dough comes back to you in a pattern that looks like this - like
every six months they pay thirty bucks and it's $60 a year, got it? nice. you get
the total of sixteen hundred bucks back from your investment and the cash that
came back to you you know came in small parts all along the way, until you got [list of yearly returns]
about two thirds of it or sixty percent at the end right? if you just spent that
money and collected your thousand bucks at the end that's it. okay so that's
arithmetic compounding/ the money comes to you if you don't reinvest it.
ding-ding-ding that's the key here and you just go buy burgers. okay so now
let's look at what six percent compounded looks like over the same
10-year period .well at the end of year one it's a thousand sixty bucks and note
we're only gonna compound it annually we probably should do the semi-annually but [list of yearly compounds]
we'd confuse you even more so don't do that. but then you essentially reinvest
that money and you get another six percent compounded on that thousand
sixty , instead of six percent compounded against the original thousand. so by the
end of year two you'll have a thousand one hundred twenty three sixty. and by
the end of year ten you'll have one thousand seven hundred and ninety
dollars and eighty-five cents. so why do you make so much more money when you
compound interest versus getting 30 bucks twice a year like you would in
this bond example? go and find burgers with it? yeah .you don't want to do that
well essentially what's happening is that you're delaying your gratification [man in a drive through window]
of getting that sweet sweet cash or getting liquid whatever you want to call
it. by reinvesting your gains year after year after year. so do you have that sort
of self-control? do you need the cash yeah that's the question if you for
example have trouble making it home from your local pizza spot with the pie
in tact well then compound interest keeping the discipline to not spend the [man eats pizza while driving]
money today and wait for the happiness tomorrow well when that may not be for
you. sorry
Up Next
What is recapitalization? Pay attention the first time, there won't be a recap.