Capitalization rate (cap rate)
A capitalization rate is the rate that expresses the risk in a business’s earnings in a going-concern valuation. The CRA says the risk is expressed in the calculation as the capitalization rate, and the valuator must exercise judgment on which factors are relevant to it.
You may meet the capitalization rate in a valuation report or a banker’s valuation of a small business. BDC places capitalized cash flow among the income-based approaches and says it is used when cash flow is expected to remain stable in future years, while discounted cash flow is used when it is expected to fluctuate substantially. The rate is the number that carries the risk judgment.
What drives it
The CRA’s Policy Statement on Business Equity Valuations says the risk, expressed as the capitalization rate, relates to factors in the business, and that the valuator must exercise judgment on how relevant they are. Its list includes:
- The tangible asset backing
- The financial condition of the specific business being valued
- The stability or irregularity of the maintainable level of earnings or cash flows
What to ask
Ask the valuator how the rate was chosen and which earnings figure it was applied to. The rate and the earnings are judgments together. For the other approaches, read business valuation methods compared and discounted cash flow.
Sources
This definition is checked against primary sources. Links were last confirmed on the dates shown.
- 01Canada Revenue AgencyGovernmentPolicy Statement on Business Equity Valuations
- 02Business Development Bank of CanadaGovernmentBusiness acquisitions: How to value a company
- 03Business Development Bank of CanadaGovernmentHow to value a business you’d like to acquire
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