The method of capitalization of income and its derivatives

Determining the value of future income of an enterprise or firm is achieved through the use of the capitalization method, as well as more complex, but more accurate - discounting of flows.

Here we will consider in more detail the first of them - the method of capitalization of income. As a rule, it is used in those situations when the firm's revenues from the operation of certain objects subject to evaluation are stable. In this sense, this method is opposite to the method of discounting, since the latter is used in cases of income instability within the forecasting time under consideration. For both cases, the most difficult issue is the forecasting of revenues for some future period. If the method of capitalization of income is used, only the first year's income is taken for analysis (provided that the assumption is made of maintaining the same yield in the following years).

Together, these two methods form the basis of the income approach, which makes it possible to accurately reflect the views of investors about the object that is evaluated and, possibly, in the future will serve as a source of revenue. This approach is interconnected with others - comparative and costly, and some of their procedures and elements are included in the algorithm of income analysis. The most sensitive drawback of this analysis is that it is based on forecast assumptions and, in the event of an unstable economic situation, may show untrue results.

In the most general form, capitalization of income is a process in which the magnitude and intensity of the income stream is transformed into an indicator of value (C). This is determined either by dividing or multiplying the amount of the flow (D) by the multiplier (M), which in economics is also referred to as the capitalization coefficient (K). The general formula of this process is as follows:

C = D / M (K), or C = D x M K).

The method of capitalization of income is applied as follows. First, a certain analogue of the evaluated object is determined, as a rule, the basis for this choice is the statistical data on the completion of this type of transactions in an approximate period. That is, the success of the calculation depends on how much the chosen analogue will adequately reflect the characteristics of the real object of evaluation. Then the capitalization coefficient is calculated by the formula:

R = Y / V

In which R is the total ratio, Y is the estimated (estimated for the analogue) net income, V is the estimated cost of selling the analog. Then the probable cost of the real object is determined, for which the formula is used:

V = Y / R.

The method of capitalization of income can also be used in cases when it is necessary to evaluate the profitability of other assets taking into account the influence of other factors. So, for example, the method of capitalization of net income is widely used. It is most effective when predicting a stable income with a high degree of probability. Another example is the study of what will be the return on capital, a method of direct capitalization. Its main feature is that when determining the capitalization coefficient, information on prices and incomes is applied, which, of course, entails a change in the calculation formula. It takes the following form:

K = V / Y.

Fundamental principles of this method are widely used in calculating potential dividends, the effectiveness of the application of multipliers, the construction of possible projects of company growth models, studies of debt and equity, land, real estate and fixed assets. Modified variants of the method is Ellwood's method.