Capitalization Rate

By its very nature, business valuation is focused on the buyer’s perspective. For instance, the appraiser has to determine how much return on investment a buyer would demand, or to say it another way, how quickly a buyer would wish to recover the purchase price. These issues are closely related: the latter is a multiplier, and its inverse is a capitalization or discount rate.

Return on Investment

A discount or capitalization rate is used to determine the present value of the expected returns of a business. Generally speaking, the capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment. The after-tax net cash flow of a business is divided by the capitalization rate to derive the present value. There are several different methods of determining the appropriate discount rates; the most common method is known as the Ibbotson build-up method. The discount rate is comprised of two elements: (1) the risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, such as a government bond; plus (2) a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate.

Ibbotson Build-Up Method

The Ibbotson Build-Up Method is a widely-recognized method of determining the after-tax net cash flow discount rate, which in turn yields the capitalization rate. The figures used in the Ibbotson Build-Up Method are derived from a publication entitled Stocks, Bonds, Bills and Inflation Yearbook (“SBBI”), published annual by Morningstar (formerly Ibbotson Associates) since 1977. SBBI is the result of a study initiated by Professor Roger Ibbotson of the Yale School of Management, who studied the relationship between risk and return among various classes of assets: government bonds, large cap stocks, and small cap stocks. Ibbotson’s study was intended to quantify the benefit of portfolio diversification in reducing risk. His study also proved useful in enabling valuation professionals to develop the cost of capital for business valuations.

The Ibbotson method is called a “build-up” method because it is the sum of risks associated with various classes of assets. It is based on the principle that investors would demand a greater return on classes of assets that are more risky. The first element of an Ibbotson Build-Up capitalization rate is the risk-free rate, which is the rate of return for long-term government bonds. Investors who buy large-cap equity stocks, which are inherently more risky than long-term government bonds, require a greater return, so the next element of the Ibbotson Build-Up method is the equity risk premium. In determining a company’s value, the long-horizon equity risk premium is used because the Company’s life is assumed to be infinite. The sum of the risk-free rate and the equity risk premium yields the long-term average market rate of return on large public company stocks.

Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater return, called the “size premium.” SBBI publishes the size premiums for ten deciles, broken down according to market capitalization size. Beginning with the 2001 SBBI publication, the tenth decile has been further split in half, calculating the returns on the smallest five percent (sub-decile 10b) and the second smallest five percent (sub-decile 10a).

By adding the first three elements of an Ibbotson Build-Up discount rate, we can determine the rate of return that investors would require on their investments in small public company stocks. These three elements of the Ibbotson Build-Up discount rate are known collectively as the “systematic risks.”

In addition to systematic risks, the discount rate must include “unsystematic risks,” which fall into two categories. One of those categories is the “industry risk premium.” Ibbotson’s yearbooks contain empirical data to quantify the risks associated with various industries, grouped by SIC industry code. The other category of unsystematic risk is referred to as “specific company risk.” No published data is available to quantify specific company risks. Instead, specific company risks are determined by the valuation professional, based upon the specific characteristics of the business and the professional’s reasonable discretion applied to appropriate criteria.

It is important to understand why this capitalization rate for small, privately-held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels of risk than an investment in a closely-held company. Depository accounts are insured by the federal government (up to certain limits); mutual funds are comprised of publicly-traded stocks, for which risk can be substantially minimized through portfolio diversification; and real estate almost invariably appreciates in value of long time horizons.

Closely-held companies, on the other hand, frequently fail for a variety of reasons too numerous to name. Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no federal guarantees. The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why investors demand a much higher return on their investment in closely-held businesses; such investments are inherently much more risky.