Capitalization Of Earnings

  

Categories: Stocks, Bonds, Banking

Earnings came in a blip. That huge Ship-in-a-Bottle project was completed and, in this quarter, your company earned $18 million. But the number is kind of misleading, because your next huge Ship-in-a-Bottle won't be finished for a year-and-a-half. So rather than just have $18 million to the good, followed by 6 quarters of "to the bad," you capitalize your earnings and recognize them "ratably" over the next 6 quarters as $3 million a quarter.

It’s easy to look at the present value of a business: just look at their current cash flow, earnings, and other presently-available info. But what about the future? It’s the future we care about, because decisions we make now will have consequences in the future. If only there was a way to figure out how much a company is worth now and in the future…

Okay, we know, you’ve been through this wringer before, so you know what’s coming next. Yes, there is a way to determine the value of a company now and in the future. It’s called the capitalization of earnings.

The capitalization of earnings uses the net present value (NPV) of expected future profits or cash flow. This helps investors weigh the benefits and costs (potential risk) before they decide whether or not to put their bucks towards a company.

More specifically, the capitalization of earnings is when you divide the company’s future earnings by the “cap rate,” which is net operating income divided by purchase price. The downside to this is that, of course, we still don’t know the future for sure. Estimated future earnings may be inaccurate, or something like a stock market crash could happen. You never know.

Related or Semi-related Video

Finance: What is Market Capitalization v...171 Views

00:00

finance a la shmoop- what is compounding value or compounding interest? ah the

00:08

power of compounding. it makes trees stronger pollution more feral and the

00:14

rich well richer. how so well let's start with compounds kissing

00:18

cousin with six toes, arithmetic compounding. right so the first was [feet with six toes pictured]

00:23

really geometric compounding now we're talking about arithmetic compounding. if

00:27

you invest a thousand bucks in a ten-year bond that pays 6% of a year in

00:30

interest, the dough comes back to you in a pattern that looks like this - like

00:35

every six months they pay thirty bucks and it's $60 a year, got it? nice. you get

00:41

the total of sixteen hundred bucks back from your investment and the cash that

00:45

came back to you you know came in small parts all along the way, until you got [list of yearly returns]

00:49

about two thirds of it or sixty percent at the end right? if you just spent that

00:53

money and collected your thousand bucks at the end that's it. okay so that's

00:58

arithmetic compounding/ the money comes to you if you don't reinvest it.

01:01

ding-ding-ding that's the key here and you just go buy burgers. okay so now

01:06

let's look at what six percent compounded looks like over the same

01:10

10-year period .well at the end of year one it's a thousand sixty bucks and note

01:14

we're only gonna compound it annually we probably should do the semi-annually but [list of yearly compounds]

01:18

we'd confuse you even more so don't do that. but then you essentially reinvest

01:21

that money and you get another six percent compounded on that thousand

01:25

sixty , instead of six percent compounded against the original thousand. so by the

01:30

end of year two you'll have a thousand one hundred twenty three sixty. and by

01:34

the end of year ten you'll have one thousand seven hundred and ninety

01:37

dollars and eighty-five cents. so why do you make so much more money when you

01:41

compound interest versus getting 30 bucks twice a year like you would in

01:46

this bond example? go and find burgers with it? yeah .you don't want to do that

01:50

well essentially what's happening is that you're delaying your gratification [man in a drive through window]

01:53

of getting that sweet sweet cash or getting liquid whatever you want to call

01:58

it. by reinvesting your gains year after year after year. so do you have that sort

02:04

of self-control? do you need the cash yeah that's the question if you for

02:08

example have trouble making it home from your local pizza spot with the pie

02:12

in tact well then compound interest keeping the discipline to not spend the [man eats pizza while driving]

02:16

money today and wait for the happiness tomorrow well when that may not be for

02:20

you. sorry

Up Next

Finance: What is recapitalization?
34 Views

What is recapitalization? Pay attention the first time, there won't be a recap.

Find other enlightening terms in Shmoop Finance Genius Bar(f)