by The Earning Capacity Method of share valuation determines a company’s worth based on its ability to generate future earnings. It focuses on sustainable profits and compares them to the expected rate of return. The formula used is:
Value per Share = [Average Maintainable Profit / Normal Rate of Return] × 100
This method is useful in mergers, acquisitions, and investment decisions, as it reflects the company’s profitability rather than just its assets. It is widely preferred by investors seeking long-term financial stability and growth potential in a business.
Assumptions of Earning Capacity Method:
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Stable and Maintainable Earnings
This method assumes that the company’s past earnings represent its future earning potential. It considers average maintainable profits over several years to ensure stability and consistency in valuation. Fluctuations in profits are adjusted by excluding abnormal gains and losses, making the valuation process more realistic for investors and stakeholders.
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Consistent Business Operations
It assumes that the company’s business operations will continue in the future without significant disruptions. External factors such as economic downturns, technological changes, or regulatory shifts are not considered unless they permanently impact earnings. This helps in maintaining the reliability of estimated future earnings.
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Normal Rate of Return Remains Constant
The method assumes that the normal rate of return (NRR) remains stable over time. NRR is based on industry averages, market conditions, and investor expectations. If interest rates or risk factors fluctuate significantly, the valuation may not reflect the actual market value of shares.
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Profits are Distributed to Shareholders
It is assumed that the company distributes profits fairly in the form of dividends or reinvestment for future growth. Investors rely on these profits to assess the value of shares. If a company retains all earnings without benefiting shareholders, the valuation might not be relevant.
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No Extraordinary Gains or Losses
The method assumes that the company’s financial performance does not include one-time income or expenses such as asset sales, lawsuits, or restructuring costs. Only regular business operations are considered, ensuring that the valuation reflects the true earning power of the firm.
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Future Business Conditions Resemble the Past
This assumption states that market conditions, competition, and industry dynamics will remain similar to past trends. Any significant economic, political, or technological changes that could impact the company’s future earnings are generally ignored, making the valuation less sensitive to uncertainty.
