Company valuation using the capitalized earnings value method

What is the capitalized earnings value method? – Definition and classification

The capitalized earnings value method is one of the overall valuation methods. The aim is to determine the company value on the basis of future financial surpluses. It is therefore a future-oriented valuation model in which not only past values are considered, but above all the question: What will the company earn in the future – and what is this income worth today?

The enterprise value is essentially derived from the present value of the forecast profits for the coming years and is supplemented by a so-called perpetual annuity.

The term “perpetual annuity”

The term “perpetual annuity” – also known as “terminal value” – refers to the part of the enterprise value that results from the earnings after the specific planning period. It is assumed that the company will generate a constant profit from the last planning year onwards for an indefinite period.

For small and medium-sized companies in particular, the perpetual annuity often accounts for the largest share of the capitalized earnings value – often over 75%. This makes it all the more important that the underlying assumptions are realistic and professionally derived.

In detail: How does the capitalized earnings value method work?

The capitalized earnings value method calculates the company value based on its expected future profits – these are discounted to the present day using a specific interest rate. This results in a value that realistically reflects the future earning power. The process is divided into several steps:

1. Define planning period:
   
   First, a realistic period is defined, usually between three and five years. The expected annual surpluses (after adjustment) are forecast for this period.
   
   
2. Clean up financial data:
   
   This is followed by an analysis of the income statement and balance sheet. Extraordinary, out-of-period or non-operating items are eliminated to present the actual economic situation. The aim is to create a reliable basis for the valuation.
   
   
3. Determine capitalization interest rate:
   
   The interest rate used to discount future profits consists of a risk-free base interest rate (e.g. long-term German government bonds) and a company-specific risk premium. The higher the capitalization interest rate, the lower the company value – and vice versa.
   
   
4. Discounting cash flows:
   
   The planned annual surpluses are discounted to the present day using the capitalization interest rate. This results in the present value of the expected profits during the planning period.
   
   
5. Calculate perpetual annuity (terminal value):
   
   From the end of the detailed planning period, it is assumed that the company will generate a constant profit in the long term. This perpetual annuity is also calculated using the capitalization rate and discounted to today’s value. In practice, it often accounts for the largest share of the total value.
   
   
6. Calculate equity value:
   
   The sum of the present values of the individual years plus the perpetual annuity gives the equity value.

This structured approach shows: Even if the process is logically structured, it requires a great deal of specialist knowledge and experience – especially when it comes to selecting realistic parameters. Therefore, professional advice and evaluation is always the safest way forward.

Who is the capitalized earnings value method suitable for?

In principle, the capitalized earnings method is suitable for companies that have been on the market for several years, generate stable earnings and operate in a comparatively constant economic environment. It is traditionally used in particular for M&A transactions or family succession solutions.

Typical fields of application:

• Medium-sized companies with predictable business models
• Family businesses with succession planning
• Company sales in the context of strategic restructuring

Limits of the capitalized earnings value method

Despite its strengths, the capitalized earnings method is not the best choice in every situation and is therefore not a standard solution. The method quickly reaches its limits, particularly in dynamic markets or for start-ups whose earnings fluctuate greatly.

The result also depends heavily on subjective assumptions – for example, when selecting the capitalization rate or forecasting future profits. A small change in assumptions can have a major impact on the result.