In its simplest form, the Capitalization of Earnings Method converts an expected income level into value by dividing income by a capitalization rate. This method has the following characteristics:
- Often used to value large companies which are assumed to continue in existence in perpetuity.
- It does not separately consider the value of operating assets.
- It assumes all operating assets will be replaced through a deduction for depreciation which is used in determining the earning capacity of the business.
- It assumes that all value of the business is found solely in its earnings.
The method might be used for small closely held businesses when earnings are in fact the sole source of business value. Extreme caution should be used when attempting to use this method. Applying it to the wrong “type” of earnings will spell disaster in the divorce valuation.
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