# Definition of capitalized earnings

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.

If we set aside detailed planning for future financial years, we can proceed with a simplified calculation of capitalized earnings. To do this, long-term operating profit is estimated, then discounted with the capitalization rate:

Long-term operating profit * 100
Capitalized earnings = ---------------------------------------------------------------
Capitalization rate

As a general rule, the valuation of future earnings is often based on the adjusted average operating profit for the last three years. When being calculated, annual figures are adjusted based on non-operating expenses and earnings which are outside the period and extraordinary in nature, along with an objective salary for the entrepreneur.

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: 1.5%
• Market risk premium: 4% to 5%
• Rate for small companies: 1% to 3%
• Rate of non-liquidity: 1% to 3%
• Rate for risk specific to the company: on a case-by-case basis (usually between 1% and 10%)

Calculation of the capitalization rate, particularly in the area of risks specific to the company, requires a subjective valuation of several factors such as position on the market, customer risk, supplier risk, personnel risk, etc. Bearing in mind the fact that even the slightest change made to the capitalization rate can have a major influence on capitalized earnings, it is not surprising that this point is the subject of much debate.

Source: KMU Diamant Consulting AG – Unternehmensbewertung, interview dated 05.31.2015.

Last modification 21.02.2020