If you are valuing a business by using capitalization of income methods you may have to be extra careful in selecting the right capitalization rate. The cap rate is just the difference between the discount rate, which captures the company’s risk profile, and the earnings growth rate over the long term.
Sounds simple enough, but yet the incorrect choice of the cap rate is the most common source of mistakes. Say, for example, your discount rate is 35% and you use the 5 year earnings forecast to come up with an earnings growth rate of 55%. The cap rate, being the difference between the two is a negative -20%! What gives?
While negative cap rates are mathematically possible, they make no financial sense. The calculated business value becomes a negative number – an impossible result. The reason for this confusing situation is that the earnings growth rate is overstated, given the company’s discount rate.
To address this problem, carefully review your earnings growth expectations. A company may go through a period of rapid earnings growth on occasion. Perhaps you have acquired new technology, access to a protected market for a while, or favorable customer contracts.
These types of advantages may lead to business earnings rising rapidly in the short term. However, market forces eventually balance this situation. New competitors become attracted to the market place. The overall market saturation occurs where existing customers are no longer buying as much or new customers become harder to find.
The result is your earnings growth rate over the long haul is bound to drop below the discount rate, or the business risk factor. The result is that the cap rate is a positive number.
So it is important to figure out what the sustainable long term earnings growth is likely to be. For guidance, look to your industry sector. What is the historic sector growth rate? How are the major established competitors growing?
If your industry sector is growing at 5% annually on average, and you predict a 20% increase in earnings, this is likely to be due to short term opportunities. Sooner or later competitive forces in the market will bring your growth rate down to about the market average.
One of the best valuation methods to use for a company going through a rapid growth spurt is the discounted cash flow technique. You can forecast annual earnings for the entire super growth period. Then calculate the so-called terminal business value using the long-term earnings growth rate that is more in line with the industry prospects.