Capitalization of earnings is a method used by investors or potential investors to project the estimated value of an investment by calculating the current cash flow in conjunction with any expected risks. The cash flow of a business refers to the day-to-day earnings from that business, while capitalization is returns on investment in terms of profit. The capitalization of earnings method allows investors to measure the estimated returns from a number of potential investments against the risks with the aim of determining the best deal.
A simple illustration of capitalization of earnings can be shown by using the example of an investor who has some money to invest. Say the investor has the choice of investing in one of three apartment complexes named A, B and C. Apartment A is located in a good neighborhood, and each unit is rented out at $1,500 US Dollars (USD) per month. Apartment B is located in a slightly less safe neighborhood, but each unit goes for $1,500 US Dollars (USD) as well. Then, apartment C is located in a somewhat unsafe neighborhood, and each apartment goes for $1,000 US Dollars (USD) per month. Apartment C has 150 rental units, while apartments A and B have 70 units each. Each complex building cost the same amount.
The potential investor will apply the capitalization of earnings in this situation by considering the capitalization versus the risk. Apartment C might seem like a good deal, but the fact that the neighborhood is unsafe is a risk that affects the investment by keeping potential renters away, leaving some units empty. Also, apartment B is not a good investment when apartment A is available for the same price and is located in a better area.
Apartment A will yield the best returns over time because it is in a good neighborhood, and the demand for rental units in that part of town is high. Such an investment can even appreciate in the future as the forces of demand and limited supply work to drive the price of renting apartments in that neighborhood upward. As such, the capitalization of earnings forecast for apartment A is the best out of the available choices.
Capitalization of earnings can also be applied to other investment choices besides just real estate. The only drawback to this method of potential income valuation for investments is that the investment must have a projectable cash flow. For instance, capitalization of earnings can be applied to rental units because the expected income from the units can be determined up to a set time limit. This income can then be compared to the risks to find out if the investment is worth the asking price.