CAPITALIZATION RATE

A capitalization rate ("cap rate") is the interest rate at which earnings, dividends, or cash flows are converted into value or equity. (The root word of capitalize is capital, meaning equity interest.) A confusing aspect of the term "cap rate" is that some people use it to mean a whole number to multiply against the earnings measure, whereas others interpret it as an interest rate by which an earnings figure is divided. Mechanically, the conversion of earnings to capital is done by either dividing or multiplying the selected earnings figure by the cap rate appropriate under the circumstances. The conversion formula will be one of the following:

(Where cap rate is stated as an interest rate)
or

(Where cap rate is stated as a multiple)

Since the more common use of the term is as an interest rate to be divided into an earnings figure, the remainder of this essay will use cap rate in that context. To think of it in the reverse, simply take the reciprocal.

Another confusion about cap rates is that they are occasionally used interchangeably with discount rates. They are differentiated by the fact that the discount rate is applied to a series of adjusted future earnings figures, whereas cap rates are applied to a static measure of earnings.

The cap rate is a function of the riskiness of the subject earnings, considering volatility, the time horizon, and the size of the entity involved. The greater the risk, the higher the cap rate will be, thus the lower the capitalized value, and vice versa. This is because given identical cash flows or earnings, investors will place a lower value on those whose future receipt is perceived as riskier; that is, they will be more deeply discounted. Low-risk ventures, on the other hand, will have their earnings discounted only mildly, as there is less uncertainty about the return to the investor.

Probably the most common example to illustrate the cap rate concept is the stock market's price to earnings multiple (the "price/earnings ratio," or P/E ratio): the reciprocal of this multiple is the market's cap rate for that equity issue. As an example, if a company's stock is trading at $40 per share and its earnings per share (EPS) is forecast at $2.50, the P/E ratio is 16. Since the cap rate we have defined is the reciprocal of the P/E ratio, it equals 1/16, or. 0625 (6.25 percent).

Care must be exercised when applying cap rates to make sure that factors such as inflation, growth rates, and maturity are understood and properly taken into consideration. For example, cap rates calculated by reference to market rates of return are usually stated in nominal terms and therefore include an element representing inflation. Since the amount of earnings or cash flow being capitalized is static, it is stated in real terms, which means that it does not include escalation for future inflation. In this case, the cap rate has to be converted into a real basis by subtracting an estimate of inflation from the observed nominal rate.

Another situation to be wary of is when the cap rate is determined by reference to comparable companies, such as taking the reciprocal of the stock market P/E ratio. The stock market includes expectations about future earnings, including the estimated rate of growth in earnings in its determination of market price. P/E ratios will often be significantly affected by the market's expectation of future growth rates of earnings. For example, two companies with similar earnings and similar risk characteristics may have vastly different growth prospects, due to some outside factor such as management skill or favorable contractual arrangements. The company with the faster growth prospects will have a lower cap rate to divide into its earnings, therefore, other things being equal, will have a higher value.

Ideally, cap rates are applied to forecasted earnings or cash flows. This follows logically since value is based on future, not past, outcomes. As a result, one has to be careful when drawing inferences from published P/E ratios. Most P/Es are calculated using "trailing" or the prior year's earnings. Many investment research houses calculate P/Es based on forecasted earnings.