Capitalization Rate

Definition

A value, typically expressed as a fraction, used to divide a business economic benefit to arrive at the business value.

What It Means

Capitalization rate or Cap rate, is a divisor used to convert a single-point business economic benefit into the business value. The typical economic benefit used in business valuation is business earnings such as the seller’s discretionary cash flow, net cash flow or EBITDA.

Note that the capitalization rate is the reciprocal of the business valuation multiple which is used by the Multiple of Discretionary Earnings business valuation method.

Capitalization rate equals earnings growth adjusted discount rate

Capitalization rate is related to the discount rate through the following formula:

Cap = Disc - G

In this formula Cap is the capitalization rate, Disc is the discount rate, and G is the expected annual long-term growth rate in the business earnings being capitalized.

Similar to the discount rate, you can use one or more cost of capital models to calculate the capitalization rate.

To estimate the capitalization rate, first build up the discount rate, estimate the long-term earnings growth rate G, then apply the formula above.

Cap rate is used as one of the key inputs into the Capitalization of Earnings income-based business valuation method.