Capitalization Rates:
An Important Aspect in Determining Value
By David Fox 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. |
