Capitalised Earnings Method Calculation

In the subjective capitalised earnings method (according to IDW S 1), the net cash flow is discounted using an individual tax-corrected calculation interest rate (endogenous marginal interest rate) of the person concerned in the respective period. If necessary, the net cash flow is corrected by a risk discount or the calculation interest rate is increased by a risk premium. The subjective capitalised earnings method has existed long before IDW S 1 and is the original capitalised earnings method.

The objectified capitalised earnings method according to IDW S 1 derives the base interest rate and the risk (market risk premium * beta factor) from a model called Tax-CAPM, which is then used to discount the net cash flow corrected for tax.

The simplified capitalised earnings method according to § 202 BewG originates from German tax law. The profit of the last three years is corrected, summed, divided by three, and taxed at a flat rate of 30%. This sustainable profit is currently multiplied by a capitalisation factor of 13.75, which corresponds to a calculation interest rate of 7.27%. The capitalisation factor can be calculated using the reciprocal of the calculation interest rate and vice versa.

The capitalised earnings method according to §§ 27-34 ImmoWertV is explained separately in the capitalised earnings method according to ImmoWertV.

Extension by Growth

The initial example is expanded by growth. The company's cash flow increases annually by 2% (inflation). A purchasing power adjustment is to take place. The value is determined as follows:

12000 / (0.05 - 0.02) = 400000 MU. The company is worth 400000 MU. Specifically, not all of the interest income can be distributed, as the investment must be increased to compensate for the increase in cash flow.

If the investment interest rate had now increased by the inflation rate (5% + 2% = 7%), the company would be worth 12000 / (0.07 - 0.02) = 240000 MU. In practice, the interest rate is strongly dependent on inflation.

Table 2: Company Value Calculation incl. Growth

Expansion by Growth and Taxes

The initial example is now extended to include both growth and taxes. When both growth and taxes are considered, the value of the company is calculated as follows:

8400 / (0.0375 - 0.02) = 480000 MU. The calculation assumes that the cash flow increases by 2% but is also subject to 30% taxation.

Table 4: Company Value Calculation incl. Growth and Taxes

Capitalised Earnings Method with Detailed Planning Period

Let us now assume that the cash flow continues to grow in line with inflation and is taxed at 30%. There is no risk, and if there were, it would be corrected directly in the cash flow. The investment interest rate, however, is 7% in the first year, 6% in the second year, and from the third year onwards 5% (perpetuity). The investment interest is again taxed at 25%, so the net interest is 5.25%, 4.5%, and 3.75%. Each period and finally the perpetuity must be discounted individually. Compound interest is also considered.

Year 1: 8400 * (1 + 0.0525)^-1 = 7981 MU

Year 2: 8568 * (1 + 0.045)^-1 * (1 + 0.0525)^-1 = 7790.06 MU

Year 3: 8739.36 / (0.0375 - 0.02) * (1 + 0.045)^-1 * (1 + 0.0525)^-1 = 437638.06 MU

The sum amounts to 469820.55 MU. This is the amount that must be invested to receive the same cash flow as through the company. The example illustrates this. It can be seen that the data from year 3 in Table 5 match the data from Table 4.

Note: The planning period is divided into a clearly plannable period such as 5-10 years, and then a perpetuity is applied at the planning horizon.

Table 5: Company Value Calculation with Detailed Planning Period

The capitalised earnings method according to IDW S 1 is described in particular in margin nos. 102-123. A distinction is made between a subjective and an objectified capitalised earnings method. The subjective form is described in margin no. 123. In addition to this subjective form, there is the objectified capitalised earnings method (margin nos. 114-122), which is described below.

The procedure of the objectified capitalised earnings method according to IDW S 1 is simplified as follows:

• A planning period is defined (e.g., 5 years), and then a perpetuity (or a present value) is applied.
• Planned balance sheets and profit and loss statements are prepared to determine the sustainable profit.
• The calculation interest rate is determined and derived from a model called Tax-CAPM (Brennan, 1970). Specifically, a risk-free base interest rate is determined, which is then supplemented by a risk premium (market risk premium * beta factor). This interest rate is then discounted with a (typified) personalized tax rate. Furthermore, the interest rate at the planning horizon is corrected by a growth factor.
• The net cash flow is discounted using the calculated calculation interest rate.

Planning Period

• Base Interest Rate +
• Market Risk Premium * Beta Factor =
• Gross Interest Rate
• Gross Interest Rate * (1 - Tax Rate) =
• Net Interest Rate

At the planning horizon (perpetual)

• Base interest rate +
• Market risk premium * beta factor =
• Gross interest rate
• Gross interest rate * (1 – tax rate) –
• Growth rate =
• Net interest rate

The procedure is similar to the subjective capitalised earnings method (in accordance with IDW S 1). The difference is that the starting point is not the individual calculation interest rate, but an objectified interest rate consisting of base rate + market risk premium * beta factor. Although the value is therefore more “objective”, it is irrelevant for the valuation subject. Detailed and accurate criticism of why the objectified capitalised earnings value method according to IDW S 1 should not be used for decision-making purposes can be found in Matschke and Brösel (2013).

This will be illustrated here using an example. The gross cash flow for the company is 12000 MU and 8400 MU after tax (30%). The cash flow trends in line with inflation of 2%.

In the subjective capitalised earnings method (in accordance with IDW S 1), the interest rate is set at 5% before and after taxes of (25%) 3.75%. This is what he actually gets from his bank. The value is 8400/(0.0375-0.02) = 480000 MU. As the example shows, the sale price compensates for the lost cash flow through the interest income. In this example, risks are not taken into account due to subjectively certain expectations (expectancy value).

Table 6: Company Value Calculation Capitalised Earnings Method (Subjective)

For the capitalised earnings method according to IDW S 1 in its objectified form, a base interest rate of 4% and a market risk premium of 4.5% apply. These data, as well as the beta factor of 1.05, are normally derived from the TAX-CAPM model. Added together and adjusted for taxes, the interest rate is (0.04+0.045*1.05)*(1-0.25) = 6.54%.

This results in a value of 8400/(0.0654-0.02) = 184869.36 MU.

The objectified capitalised earnings value method in accordance with IDW S 1 implies that the alternative investment is in the same risk class with the same level of debt.

Table 7: Company Value Calculation Capitalised Earnings Method According to IDW S 1 (Objectified)

However, the valuation subject invests its money with the house bank and attempts to obtain the same withdrawal flow as before the sale. His capital decreases every year because the interest income is not sufficient to compensate the former cash flow. The reason is that the objectified capitalised earnings method according to IDW S 1, like the DCF method, does not consider the subject’s real alternative investment, but a fictitious investment on the capital market. Decisions should therefore not be based on the objectified capitalised earnings method according to IDW S 1. However, it does provide a good basis for argumentation, as it is widely used and respected in Germany.

It may be criticised that the figures in the example are arbitrarily chosen, but it nevertheless shows the following very well. The business value, which was calculated using the objectified capitalised earnings method according to IDW S 1 and not the subjective capitalised earnings method (according to IDW S 1), coincides at best with the decision value by chance. Wrong decisions happen frequently. Discrepancies are possible both upwards and downwards.

For more information on a business valuation and an appraisal according to IDW S 1, you can find the link here.

Here you have the option of using a calculator for the capitalised earnings method. The net cash flow is a series of numbers (vector). The net interest rates and risk premiums are also vectors. However, if a single figure is entered, it is extended to the length of the vector of the cash flow. The risk premium is optional. The growth rate is a number. If no perpetuity is to be specified for the planning horizon, the number of years in the planning horizon can be entered for a present value factor. The last figures in the respective vectors (net cash flow, net interest rates, risk premiums) are relevant for the perpetual annuity or the present value factor on the planning horizon.

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Laux, H., & Franke, G. (1969). On the Problem of Valuation of Enterprises and Other Investment Goods. Unternehmensforschung, 13, 205–223.

Matschke, M. J., & Brösel, G. (2013). Business Valuation: Functions—Methods—Principles (4th ed.). Springer.

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Terstege, U., Bitz, M., & Ewert, J. (2023). Investment Calculation Made Simple. Springer Gabler.

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