Valuing a business? Make sure your capitalization rates are positive!

Whether you are valuing an established company or a start-up, the income-based business valuation methods are a wise choice. For businesses that tend to generate a steady stream of earnings, the direct capitalization methods such as Multiple of Discretionary Earnings or Capitalization of Earnings work very well.

Using these valuation techniques you can assess the value of a business based on its ability to generate earnings at an acceptable level of risk. Direct capitalization valuation methods use the capitalization rate to capture the business risk.

Needless to say, the accuracy of your business valuation depends largely on your choice of the capitalization rate. One common problem you may have to handle is negative cap rate values.

How the capitalization rate is calculated

How can a cap rate be negative? Consider the formula used for its calculation:

C = D – G

Here C stands for the capitalization rate, D is the discount rate and G is the expected long-term growth rate in the income you are capitalizing.

If your estimate of the growth rate G exceeds your discount rate D, the calculated cap rate becomes negative.

Business risks imply a positive cap rate

While the math can produce a negative result, the economically sensible cap rates are always positive. Put differently, your business always faces certain risks.

The typical reasons for a negative cap rate calculation are:

• Underestimation of business risks that leads to a low discount rate calculation.
• Overestimation of the earnings growth the business is likely to see over the long term.

The root cause of incorrect cap rates – rosy assumptions about future business earnings and risk

When you get a negative cap rate initially, consider these factors and review your assumptions:

• Your long-term earnings growth rate estimate may not be sustainable.
• Your discount rate should capture all risks the business is likely to face.

The typical situations that can bring your long-term earnings growth rate down are:

• Additional competition enters the market. They can capture part of the market share or put a pricing pressure on your products and services.
• The initially high growth rate leads to market saturation which ultimately reduces the business sales and earnings growth.
• Current products become obsolete and need to be replaced. Product replacement can increase your expenses and reduce the earnings growth.
• As the sales grow the business needs to scale in order to continue servicing its growing customer base. The significant investments required may reduce the business cash flow.

Using what-if scenarios to refine your business appraisal

Since the income-based business valuation is forward looking, consider a number of what-if scenarios. Each can have a different set of assumptions regarding the business earnings and risk.

You can repeat your business valuation under each scenario then average the results to come up with an overall estimate of what the business is worth.

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