3.03: Capitalization rates
The fair market value of a business enterprise is usually calculated using the following formula (simplified):
FMV of the enterprise = Maintainable, normalised operational cashflows ÷ the capitalization rate.
The capitalization rate has a very significant impact on the valuation conclusion and needs to be developed with great care. Cap rates are often translated into a multiple, which is the inverse of the cap rate.
Capitalization rates have a significant impact on the valuation conclusion.
Capitalization rates (usually developed in a range, to be applied to a range of possible cashflows) are developed after a consideration of the following factors:
- Risk free rates (e.g. long-term government bonds).
- Equity premiums (i.e. the extra return available by investing in stocks instead of risk free government bonds etc).
- Industry risks (which can be estimated by comparing returns available from stocks in the client’s industry to the returns available from a broad basket of stocks).
- Economic risks (usually related to the business environment in which the client’s business operates).
- Business specific risks, which can include a wide variety of factors that take account of the strengths, weaknesses, and threats faced by the client. Among other issues, major risks include the business’s degree of dependence on management, customer groups, suppliers, or product lines.
- Expected long-term growth.
Borrowing rates also impact the business’s overall cost of capital (depending on which valuation method is used) and therefore have a major impact on the capitalization rate to be used.
Contact MVI if you would like a better understanding of how capitalization rates are determined, and/or which factors are the most influential.