By Kalman A. Barson (New Jersey)
Of all the aspects/parts of business valuation, the one that I believe raises the most questions, gets the most blank stares, from the non-business valuation community, is the phrase “capitalization rate (cap rate).” On one level, it’s fairly straight-forward to explain what a cap rate is – but on another level, it is rather complex, and the critical aspect of same is the development of the cap rate. That is, the end product – the cap rate – is generally a lot simpler to explain than is the process by which the cap rate is determined/developed.
First, the simple part – a cap rate essentially is a multiple, or perhaps more technically accurate, the inverse of a multiple. To explain and illustrate very simply, if you hear of a 20 per cent cap rate, think of a 5-multiple; if you hear of a 25 per cent cap rate, think of a 4-multiple. In other words, if you divide 100 by the cap rate percentage, you get a multiple – the number of times the cap rate goes into 100. That represents the multiple of income for determining value under the income approach. Thus, if it has been determined that the net income of a business that is to be capitalized is one million dollars, and if it has been determined that the cap rate is 20 per cent, then simplistically speaking, the value of that business is 5 million dollars – which is the result of dividing the income of one million dollars by the cap rate of 20 per cent (or .20), which is arithmetically the same as multiplying the one million dollar income by the multiple of 5 (which is the inverse of the cap rate). If, for this same business with a one million dollar income to be capitalized, it was determined that the cap rate was 10 per cent, then the multiple would be 10, and the value would be 10 million dollars.
So much for the simple part – the real issue is, how do we get to the cap rate. That is where the professional effort comes in, and where there is a fair amount of professional judgment – even where there are objective benchmarks, there are at times subjective/professional calls as to how to use what would otherwise be considered an objective set of numbers. There will be more about that as this article evolves. The essential aspect of determining the cap rate is almost universally done via the process that is called the “build-up” of the cap rate. That is, we use the equivalent of building blocks to derive the cap rate. Let’s now address those various building blocks.
Risk-free rate – this is the starting point, the basic foundation, and one with which there should be no differences between experts. We start here with the 20-year Treasury Note rate effective as of the date of valuation. This information is available from multiple sources within the public domain;
Equity-risk premium – this item, as well as the next two, are generally taken directly from the annual Ibbotson Valuation Yearbook, published by Morningstar. This premium represents the rate of return over a long period of time realized in the public stock markets by the largest companies, a rate of return that is in addition to that realized from the risk-free Treasury Notes referenced preceding;
Size premium – we have to recognize that the companies that we’re valuing tend to be smaller (typically much smaller) than the companies on the stock market, and that a basic truism in valuation and investing is that, all other things being equal, a larger company is less risky than a smaller company. Thus, we now come to the size premium where we add in (as part of our cap rate build-up) a factor (premium) for the smaller size of the companies we’re valuing. This tends to be the first area in this build-up process where we see subjective judgment calls. You will see here valuation experts using anything from the micro-cap blend to a tenth decile, to the 10b (the smaller half of the tenth decile); and possibly even fine-tuning that further. The difference can be significant – adding a premium of anywhere from as low as perhaps 3 per cent to as high as maybe 12 per cent. The impact on the determination of the cap rate of course is very significant, and similarly the resulting impact on the value of the subject business can be tremendous. A skilled valuation expert can make a good argument for any of these approaches – though similarly such justifications can be challenged. Most importantly, is the issue as to whether that expert is consistent in applying an approach regardless of which side he/she represents;
Industry-specific premium/discount – as the title suggests, this is an adjustment (and it can be an increase, as well as a decrease, to the otherwise determined build-up) based on the specific industry in which this business operates. The point here is that some industries (putting aside size factors) are inherently more risky, and others less risky, than the overall stock market. Thus an opportunity to fine-tune the risk factors. At times there isn’t sufficient information available to use this factor, and at other times, even with what appears to be sufficient information available, there are reasonable challenges as to whether the companies included in the specific industry are reasonably comparable and appropriate for the valuation of the business at hand. This represents yet another subjective professional judgment call;
Specific company risk premium – this is the ultimate in professional subjective calling, because there is no source to reference to support same (as contrasted with the two preceding items which have sources, even if experts disagree on their use). The SCRP is an additional risk factor (in theory it could be a lesser risk factor, but it almost never is) that reflects the additional risks that the valuation expert feels are appropriate to reflect in the build-up of the cap rate because of various factors unique to the subject company as contrasted with the overall pool of companies to which it is being compared and from which the cap rate has been developed. Typically, factors that play into this include the longevity of the subject company, depth of management, customer concentration, historical performance, unique exposure/risks, and just about anything else, good or bad, that may, in the appraiser’s professional judgment, be relevant to valuation;
Growth rate – everything preceding has led us up to the point of determining the discount rate. To go from the discount rate to the cap rate, one more step needs to be done, and that is to factor in the expected growth rate – which is a subtraction from the discount rate in order to arrive at the cap rate. That is, the discount rate essentially indicates the total return expected or required for an investment in the subject business. Since some of that return is going to be realized by future growth (at least in theory), then we subtract the growth to arrive at the cap rate for determining valuation. The growth rate once again is a subjective determination, but generally not as subjective as some of the other determinations. Sometimes we can get industry expectations in terms of long term growth, other times the company’s history and reasonable business practices lead us to a determination of growth. Also, as a practical matter, if one were to hypothesize a long term growth rate of several points or more, it could get to the point where the use of a too high of a growth rate puts this company into a fantasy world, thus bringing the validity and reasonableness of an assumed high rate of growth into serious question.
Presumably, our readers now fully understand how the cap rate is developed. Or, at least you can appreciate the broad concept, and that even experienced, capable, and unbiased valuation experts can conclude with different factors in the development of the cap rate.
Kalman A. Barson, CPA/ABV, CFE, CFF, is the founder of The Barson Group, a CPA firm with offices in Somerville, New Jersey. Kal and The Barson Group specialize in litigation support services – including financial investigations, income determination, business valuations, expert witness testimony, funds flow tracing, and related tax consulting and financial planning. Kal is a frequent lecturer, having spoken on behalf of the American Institute of CPA’s, the New Jersey Society of CPA’s, the Institute for Continuing Legal Education, various Bar Associations and legal groups and various other professional and business organizations. He is the author of five books on investigative accounting, as well as books on Divorce Taxation, Business Valuation, and Financial Issues in Divorce Practice.