Capitalization Methods


Investors and businesses use capitalization to value assets. They may use historical development costs or projected revenues for the valuation. Common capitalization methods include income capitalization, rent capitalization, cost capitalization and market capitalization. People use capitalization to estimate the value of real estate and businesses especially when an accurate market value is not readily available.

Income Capitalization

Investors can use the income capitalization method to value businesses and real estate property. In both cases, investors calculate the present value through discounted cash flow analysis, in which projected earnings are discounted to the present using a capitalization or discount rate. The rate includes an investor's required rate of return, which is the minimum that an investment must earn, and an adjustment for future growth. This method works well when investors can reasonably project the future cash flow stream and when reliable market data is available for income-producing properties.

Rent Capitalization

Appraisers use the land rent capitalization method to estimate land market value, according to licensed assessor Ted Gwartney of the Henry George Institute. The land market value is equal to the land rental values minus taxes, divided by a capitalization rate. The land rental value is the annual fee for exclusive use of the land, land taxes are applicable local taxes and capitalization rate is the minimum rate of return required to attract investors. A related method is the ground rent capitalization method, in which the land market value is equal to the net ground rent divided by a land capitalization rate. This procedure works best for well-developed areas where land rental and capitalization rates are readily available, according to Gwartney.

Cost Capitalization

The Internal Revenue Service suggests the cost capitalization method as a useful tool for valuing intangibles, which are assets that do not have readily available market values (for example, patents). Assessors add a capital charge to each year's development expenses, and may subtract a percentage each year for obsolescence or amortization. Obsolescence refers to the risk that a product will no longer be required, such as computer floppy disks or videocassette recorders. Amortization is the allocation of costs over an asset's useful life. The disadvantage of the cost capitalization method is that it assumes cost as a proxy for value, which is not always the case.

Market Capitalization

The market capitalization for a publicly-traded company is the number of outstanding shares multiplied by the stock price. In addition, analysts use market capitalization to value preexisting intangibles transferred under a cost-sharing agreement between multiple companies. They add the market capitalization to the book value of the liabilities and then subtract the book value of the assets. This results in the market value of the company's intangible assets, from which appraisers subtract operating intangibles (for example, goodwill) to get the value of preexisting intangibles. Book value refers to the carrying value on the balance sheet. The main drawback of this method is its reliance on an often-volatile stock market for the basic market capitalization.

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