What is the formula of Capitalisation?

Unveiling the Formula of Capitalisation: Valuing a Company’s True Worth Beyond Assets

In the intricate world of finance, valuing a company goes far beyond simply adding up its tangible assets. A company’s true worth, its capitalized value, often reflects its ability to generate profits above and beyond the norm. This article delves into a specific method of capitalization, highlighting how a company’s ‘super profit’ and the standard rate of return play crucial roles in determining its real valuation.

The core principle underlying this capitalization method lies in the understanding that a company exceeding the average profitability of its industry is inherently more valuable. This ‘excess profit,’ often referred to as ‘super profit,’ represents the additional income a company generates thanks to superior efficiency, brand recognition, innovation, or a combination of these factors.

So, how do we translate this super profit into a capitalized value? The formula is elegant in its simplicity:

Capitalised Value of Super Profit = Super Profit / Normal Rate of Return

Let’s break down each element:

• Super Profit: This is the key differentiator. It represents the difference between the company’s actual profit and the normal profit it should be earning based on its net asset value. To calculate super profit, you typically:

  • Determine the company’s average profit over a relevant period (e.g., the last 3-5 years).
  • Calculate the normal profit by multiplying the company’s net asset value (total assets minus liabilities) by the normal rate of return.
  • Subtract the normal profit from the average profit. The result is the super profit.

• Normal Rate of Return: This represents the average rate of return that similar companies in the same industry are expected to achieve. It’s a benchmark that reflects the inherent risk and opportunity within that particular sector. Determining the appropriate normal rate of return requires careful analysis of industry data, market trends, and economic conditions. This rate acts as a discount rate, reflecting the opportunity cost of investing in this specific industry.

Putting it All Together: An Example

Imagine a tech company, “Innovation Inc.,” with net assets valued at $1 million. The normal rate of return for tech companies is 10%. Innovation Inc. consistently generates an average annual profit of $150,000.

1. Normal Profit: $1,000,000 (Net Assets) * 10% (Normal Rate of Return) = $100,000
2. Super Profit: $150,000 (Average Profit) – $100,000 (Normal Profit) = $50,000
3. Capitalized Value of Super Profit: $50,000 (Super Profit) / 10% (Normal Rate of Return) = $500,000

In this scenario, Innovation Inc.’s capitalized value, based on its super profit, is $500,000 above its net asset value. This suggests that the market perceives the company as being significantly more valuable than its tangible assets would indicate, thanks to its ability to consistently outperform its peers.

Why This Method Matters

This capitalization method provides a more nuanced view of a company’s worth, particularly for businesses in industries where intellectual property, brand equity, or specialized knowledge are significant drivers of profitability. It allows investors and analysts to:

• Identify undervalued companies: Companies generating substantial super profits might be undervalued if their stock price is primarily based on their net asset value.
• Assess competitive advantages: The magnitude of a company’s super profit is a strong indicator of its competitive strength and its ability to sustain its profitability in the long run.
• Make more informed investment decisions: By considering the capitalized value of super profits, investors can make more informed decisions about whether a company’s market price accurately reflects its potential for future earnings.

Limitations to Consider

While insightful, this method isn’t without its limitations:

• Accuracy of Super Profit Calculation: The accuracy of the super profit calculation hinges on the reliability of the financial data used and the careful selection of the normal rate of return.
• Subjectivity of Normal Rate of Return: Determining the appropriate normal rate of return can be subjective and requires expert judgment.
• Short-Term Focus: The method primarily focuses on current profitability and may not adequately account for future growth prospects or potential risks.
• Not Suitable for All Businesses: This method is most applicable to established businesses with a track record of consistent profitability. It may not be suitable for startups or companies in rapidly changing industries.

In Conclusion

The formula of capitalization, using super profits and the normal rate of return, offers a valuable lens through which to assess a company’s true worth. By understanding how a company’s excess earnings contribute to its overall valuation, investors and analysts can gain a deeper appreciation of its competitive advantages and its potential for long-term success. While not a perfect measure, it is a significant tool in the arsenal of valuation techniques, especially when combined with other methods of financial analysis.