How to Arrive at a Capitalization Rate for a Business
A capitalization rate is the comparison of a variable income figure to a fixed valuation. In some cases, the variable income and fixed valuation are both known and thus the capitalization rate is objective calculated. In other cases, a subjective capitalization rate is used to convert a known variable figure into a fixed valuation. This is true in the case of valuing a business for a potential takeover: a buyer can apply a capitalization rate to the company's income figures to produce a "fair" value.
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Desired Rate of Return
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One key factor in deciding a capitalization rate is the annual rate of return investors can expect from investing in other businesses in the same industry. This could involve taking the average rate of return that has actually been paid to investors, namely the price/earnings ratio. It is best to average figures from multiple companies so that the figures aren't distorted by companies that pay disproportionately high or low dividends.
Future Growth
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Another important factor is the annual growth you expect to see in the company's earnings. You can base this on the company's previous growth, the growth of other companies in the same industry, or a combination of the two.
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Method
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One of the simplest methods to come up with a capitalization rate is to subtract the annual growth rate from the annual rate of return. Dividing the company's annual earnings by this capitalization rate will give an estimation of its value that takes into account how much it makes, how much you expect it to make in the future, and how much money you want to make in comparison to your investment.
Other Factors
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There is no objectively right or wrong way to choose a capitalization rate. While the basic principle of using forecast future earnings and desired return is consistent, there are many factors that you can choose to take into account. For example, you may wish to increase the capitalization rate, and thus lower the valuation of the business, if the rate of return offered on "risk free" investments such as government bonds is particularly high, making riskier investments less attractive.
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