The capitalization of earnings is used to value a business by deriving the net present value of its projected future earnings. The concept can also be applied to individual subsidiaries, product lines, products, and work centers to determine their value for further investment purposes. There are several issues to be aware of when using this method, which are:
- Cash flows should be discounted rather than reported earnings, since earnings information may not be indicative of the core earnings potential of a business.
- Consider the variability of projected cash flows. If the entity has had a history of variable cash flows, consider reducing the amount of future cash flows included in a capitalization of earnings calculation, or use a higher discount rate.
- There may not be enough of a prior cash flow history to create a valid set of expected future cash flows.