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.
Capitalization rate equals earnings growth adjusted discount rate
Capitalization rate is related to the discount rate through the following formula:
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.
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 Capitalized Earnings income-based business valuation method.