In the simplest terms, any asset's value, as used in an investor's financial model, is based on its expected cash flow-generating capacity and the risks associated with those expected cash flows. A multiple can be applied to a company's free cash flow, or a real estate property's net operating income, to estimate its total market value of equity. The multiple -- better defined, generally speaking, as a multiplier -- is a **capitalization rate**. It reflects the risk and return characteristics an investor associates with the cash flows of a particular investment.

## Components of the Capitalization Rate

A simplified way to calculate capitalization rates, for example with real estate projects that generate cash flow, is to divide the project's net operating income by the property's value, or the price at which similar cash-generating properties have sold for on the open market. This simple-yet-rough calculation of a capitalization rate establishes a starting point for further refinements.

A more refined version of the capitalization rate can be built up using two main components: a discount rate and long-term growth rate. The formula for calculating the cap rate equals the discount rate minus long-term growth. The discount rate is a measure of a hypothetical investor's risk and return expectations, with an emphasis on the investment's expected returns, as well as any opportunity costs associated with the investment. In other words, a discount rate is the rate of return required to entice an investor to accept the investment.

## Adjusted Capital Asset Pricing Model

Depending on the size of a company, you can find the discount rate component of its cap rate using some variation of the capital asset pricing model, or CAPM. This model accounts for all the risks within a potential investment, capturing both external market risks and company-specific risks. Any investor considering investing in the stock of a particular company or cash-generating real estate property always has the alternative option of investing his funds in a diversified portfolio of blue-chip stocks, which explains the need to pay close attention to risks of his other investment options.

Long-term stock returns reflect the risk associated with the opportunity cost of not investing the funds in a diversified stock portfolio. Long-term average stock returns minus the risk-free rate -- usually the current yield on the 20-year Treasury bond -- are known together as the risk premium. Add the risk premium plus company-specific risks to get the company's discount rate, per CAPM.

## Company-Specific Risk

Under the buildup method, the risk premium, often estimated at between 5 and 7 percent, must be adjusted upward to reflect company-specific risks. These include competitive environment risks, financial and interest rate risks. A company may also be subject to revenue concentration risks if a large part of its revenues are generated by a small number of clients or from within a specific geographic location.

Sophisticated investors have computer engineers quantifying these risks. Others must rely on conventional techniques, such as comparing financial ratios and using intuition about the company's quantitative and qualitative risks. These company-specific risks, often referred to as its alpha, can easily add 5 to 15 percentage points to a company's risk premium. Generally speaking, smaller, riskier companies such as startups have higher alphas and, therefore, higher discount rates.

## Finding the Long-Term Growth Rate

Once the company's discount rate is obtained, long-term growth must be subtracted from it to arrive at the capitalization rate. This satisfies the mathematics behind the calculation of the present value factor, which converts an income stream into value. Long-term growth should be estimated conservatively, keeping in mind that, theoretically, no company can grow at a rate exceeding the overall economy forever. Forecasted inflation rates are often a good proxy for long-term growth, but if near-term growth is expected to be high, the growth rate can be adjusted upward in small increments, such as half a percent, to reflect this.

## Applying the Capitalization Rate

In a valuation model, divide the income stream by the capitalization rate to arrive at a company's value. The capitalization rate is expressed as a percentage, while the income stream is expressed in dollars. If we arrived at a discount rate of 20 percent and a long-term growth rate of 3 percent, for example, the capitalization rate is equal to 20 percent minus 3 percent, or 17 percent. Assuming an income stream of $100, the valuation calculation would be equal to $100 divided by 17 percent, which equals $588. Note the multiplier effect of the capitalization rate. This is because dividing any number by a number less than one results in an increase. One divided by 17 percent equals 5.88. In this way the capitalization rate serves as a multiplier.

References

- PropertyMetrics: What You Should Know abotu the Cap Rate
- Aswath Damodaran: Private Company Valuation
- The CPA Journal: Developing Capitalization Rates for Valuing a Business
- National Association of Certified Valuators and Analysts: Chapter 5 -- Capitalization/Discount Rates
- Willamette: How to Estimate the Long-Term Growth Rate in the Discounted Cash Flow Method
- ValuAdder: Capital Asset Pricing Model