The capitalisation of earnings method, explained

What the method actually does

The capitalisation of earnings method converts one figure for the sustainable annual earnings of a business into a value. It divides that figure by a capitalisation rate, or multiplies it by a multiple, which is the same calculation written the other way around. The method assumes the business will keep producing roughly that level of earnings, so the two judgements that matter are the earnings figure and the rate applied to it.

It is the most common approach for established, profitable private businesses in Australia because it relies on evidence that already exists: the trading record. A discounted cash flow model needs a credible multi-year forecast, which many small businesses do not have. Where the past is a reasonable guide to the future, capitalising earnings is direct and easier to test.

Future maintainable earnings start with the historical record

Future maintainable earnings, often shortened to FME, is the level of earnings the business can reasonably be expected to sustain under normal conditions. It is usually expressed as EBITDA or EBIT for a business with employed management, or as seller's discretionary earnings for an owner-operated business. The choice of earnings measure must match the multiple applied to it, which is explained in our guide to valuation multiples.

The starting point is normally three to five years of financial statements plus year-to-date management accounts. Those years are rarely weighted equally. If the business is growing steadily, recent years carry more weight; if the latest year included an unusual contract or a disruption, a longer average may be a better guide. The weighting should be explained rather than applied mechanically, and a reviewer will ask why the chosen years represent the future.

Normalisation turns reported profit into a maintainable figure

Reported profit is prepared for accounting and tax purposes, not for valuation. Normalisation adjusts it for items that would not continue under the valuation assumptions: the owner's remuneration is reset to a market salary for the role, related-party rent is brought to a market rate, genuinely non-recurring items are removed, and private expenses run through the business are added back. Each adjustment needs a reason and a record, as set out in our guide to EBITDA adjustments.

Normalisation cuts both ways. A business that underpays its working owner, has deferred essential maintenance, or benefits from a below-market lease with a related party will see its maintainable earnings reduced, not increased. The aim is the figure a buyer could rely on, not the largest figure that can be argued.

The capitalisation rate and the multiple are the same judgement

A capitalisation rate of 25 per cent is the same thing as a multiple of 4, because 1 divided by 0.25 is 4. Practitioners tend to talk in multiples for small businesses and in rates for larger or asset-heavy ones, but the reasoning behind the number is identical. The rate expresses the return an investor would require for the risk of owning that stream of earnings, less the growth expected in it.

Four things move the rate most, starting with risk: customer concentration, supplier dependence, regulatory exposure and the volatility of past earnings all push it up. Growth: sustainable growth that is not already in the earnings figure pulls it down. Transferability: a business that depends on the owner's relationships or licences is riskier in new hands than one with documented systems and a management team. Size: smaller businesses generally attract higher rates because they have less depth to absorb a setback and fewer buyers able to fund them.

Evidence for the rate comes from transactions in comparable businesses, adjusted for the differences, and from a build-up of required returns. Either way, the report should say where the number came from and why it suits this business rather than citing an industry figure.

A hypothetical worked example, from enterprise value to equity

This example is hypothetical. The earnings, the multiple and the balance sheet items are assumed for illustration only and are not a benchmark for any industry.

Enterprise value is the value of the operating business, including the normal working capital and operating assets it needs to earn the capitalised earnings. Equity value is what the shares are worth after debt is deducted and surplus assets are added, which is why the two figures differ and why a buyer's headline number is not what an owner banks. Our guide to enterprise value and equity value sets out the bridge in more detail. A minority parcel of shares may need further adjustment for its rights.

When the method suits, and when it does not

The method suits a business with several years of reasonably stable or steadily growing profit, where the past is a fair guide to the future and the earnings can be normalised with confidence. Trades, professional practices, distribution businesses, manufacturers and established service businesses are commonly assessed this way.

It suits less well where earnings are negative, erratic or about to change materially. A start-up with a plan but no profit, a business with a defined end date such as a fixed-term contract, or one whose earnings depend on a single project needs a method that models the timing of cash flows. In those cases a discounted cash flow, an asset-based approach or a combination will be more defensible, and the report should explain why.

What to prepare before the earnings are assessed

Gather the last three to five years of financial statements, the current year-to-date management accounts, and a schedule of every adjustment you believe should be made to reported profit, with the amount and the reason for each. Add the owner's role and hours, the lease terms, and details of the top customers and suppliers, because those items drive the rate as much as the earnings.

If the valuation will be read by a tax adviser, a lawyer or a counterparty, tell us who they are and what they need before work starts. Valuation Group prepares signed capitalisation of earnings valuations from Double Bay in Sydney for businesses across Australia, from $1,495 + GST for suitable, straightforward matters. Speak with Jackson Wilson about your business, and we will explain what happens after the first conversation.

General educational information. Examples are hypothetical and do not value a real business. The appropriate treatment depends on the purpose, evidence and agreed scope.