How are Capitalization Rates and Rates of Return Related?
Capitalization rates capture both the risk and the reward of an investment.
A capitalization rate, also known as a ‘cap rate’ is a rate used to indicate the rate of return expected from the net income of the business. It is calculated by the division of the total value of the business by the expected annual net profit of the business. If known or estimated, a capitalization rate can be applied as a multiplier to the expected net profit of a business to determine its value.
For example, the landscaping company, Greener Acres Inc., received an offer from its competitor, Shady Vista Ltd. to buy all the shares of Greener Acres for $100,000. The offer means Shady Vista thinks the value of the business, Greener Acres, is worth $100,000.
Greener Acres has had a busy year and expects net profit before tax of $50,000. In this case, the capitalization rate is 2.
If Greener Acres then turns down the offer to purchase and next year grows net profit before tax to $60,000, then the value of the business could increase to $120,000.
Rate of Return
A capitalization rate can be thought of as a rate of return. A rate of return represents the amount of income an investor expects from an investment. It is calculated by the division of the income expected by the amount of the investment.
For example, Greener Acres has been in business for ten years. In the beginning, Greener Acres struggled a bit, but they got better at it. Greener Acres provided good service and over time built its customer list. Steve, the owner, got along well with his employees, helping where needed, directing where required, with the result that the employees were happy and stayed with the company. The happy employees helped build good relationships with their customers. Over time, Steve, made sure that the right equipment was available for the safety of the crew needed to do the job. Greener Acres earned $50,000 of net profit every year for the last five years.
When Shady Vista made the offer to buy Greener Acres, they were expecting a 50% return on their investment. Whoa! That’s a pretty high rate of return considering the bank was paying Greener Acres a 1% interest rate on the money in its bank account.
Risk and Reward
Shady Vista also considered the risk of buying Greener Acres. Shady Vista knew that some of the employees would not stay if Steve wasn’t running the business. Shady Vista also expected that if the employees left and Steve wasn’t around to help with the customers, then the customers could leave as well. If both Steve and the employees left, then there is a real risk the expected $50,000 net profit will not be achieved.
Capitalization rates both determine the value of the business and represent the risk inherent in the business. There is a risk that an investment might not work out the way it is intended, but if it does then the reward is great.