Capitalization Rates: An Important Aspect in Determining Value

One of the more common approaches to valuing a business as a going concern involves determining a good measure of earning power and capitalizing it. This determines the value of the business to an investor based on the future returns he or she can reasonably expect.

It’s possible to capitalize net income, pretax income, income before interest and taxes, or any earnings base. The rates will differ depending on the earnings base used. Determining the correct rate, however, is the key to finding a meaningful value. No matter how valid the method of valuation is, using an inappropriate capitalization rate can render the results meaningless. Therefore, the ability to choose an appropriate capitalization rate is essential for a business evaluator.

What Exactly Is a Capitalization Rate?

In its broadest sense, a capitalization rate is a number used to convert an income stream into a present value. Unfortunately, the term “capitalization rate” has somewhat different meanings in different applications. This can lead to confusion.

Most commonly, a capitalization rate is used to indicate a percentage rate by which a steady stream of income is divided to find value: Current Value of Business = Historical Income Stream ÷ Capitalization Rate.

How Is the Cap Rate Determined?

In many cases, the market dictates the capitalization rate used, particularly if you are seeking fair market value. The capitalization rate essentially represents an investor’s desired return — what he or she would earn by investing the same amount of money in something else with the same risk factors and anticipated income stream.

For example, Charlotte Webb is looking for the fair market value of her interior design company. The company’s net income has been fairly consistent and is expected to continue to be $100,000 annually. Her forensic accountant determines the average investor in Charlotte’s market is expecting to make a 20% return. Therefore, Charlotte’s company would be worth $500,000 to an investor ($100,000 ÷ 20% = $500,000). The 20% is the capitalization rate for Charlotte’s business, capitalizing the income stream to its current value to an investor. If the capitalization rate used were 25%, however, the value of Charlotte’s company would be $400,000. You can see what an impact the rate chosen can have on value.

If the company’s earnings were expected to grow, the capitalization rate would be adjusted downward by the expected long-term growth rate, which has the effect of increasing the value. For example, if Charlotte’s company were expected to grow at 3% per year indefinitely, the value would be $588,235 [$100,000 ÷ (20% – 3%)].

Of course this is a very simplified example and does not take into account the many other factors that could have an effect on the value. But it does illustrate the relationship between an investor’s desired rate of return and the capitalization rate.

Choosing the Right Rate

Choosing a capitalization rate is very important. Using an incorrect rate could drastically misrepresent the value because of the leveraging effect these rates have on value. Determining which rate is appropriate takes experience and an understanding of the market in which a business operates.