Thursday, October 11, 2012
What is a cap rate and why could it be relevant to your divorce? If you or your spouse own a small business or commercial enterprise, then you should understand the concept of "cap rates," because they are an integral part of the valuation process.
A capitalization rate, or “cap rate” for short, is a numerical factor that is used as part of a mathematical formula to determine the value of a business when using the income approach, which is one method of valuing a business. Sound complicated? It is, but let’s break it down further.
First, an evaluator must determine the rate for the individual business by reviewing the financial books and records. To determine the cap rate an evaluator looks at various aspects of a commercial enterprise, as well as market data. Then the evaluator assesses the following:
(1) Risk-free rate. This number is objective, and experts generally use the 20 year Treasury Note rate. Tip: If your evaluator does not use this objective number, ask why.
(2) Equity risk, size and industry-specific premiums. These factors compare the rate of return in the public stock markets, the risk associated with the size of the company being evaluated and the risk associated with the particular industry of the company being evaluated. Tip: Do you think your business is risky but the evaluator believe otherwise? Ask for an explanation of the evaluator’s decision on these issues.
(3) Risks specific to your company. Determining this factor utilizes the most subjectivity. Each company has its own unique circumstances which play a part in determining its value, including: how old is the company, how is the management structured, where do the customers come from, how has the company performed historically and what is unique that may expose the company to risk? For example, is the company dependent on contracts with the Defense Department, which are negotiated at the whim of Congress? Or, does the company depend on a specific brand or product that could lose popularity with the consumer? Different experts will have different opinions on these factors; therefore, your valuation must include credible conclusions based on comprehensive data. Tip: Do you know something about your business that will change its financial picture in the near future? If yes, share it with the evaluator.
(4) Growth rate - How is the company expected to grow? This factor utilizes industry expectations and includes some subjectivity on the part of the evaluator; thus, it must be based on credible data. Tip: What do you expect of your business in the next few years? Make sure that it matches what is in the evaluation.
Unfortunately, as is clear from the listed factors, determining the cap rate relies on both objective and subjective data, which is why two different evaluators can come up with vastly different numbers when determining the value of a business. Therefore, it is important for you, as a business owner or the spouse of a business owner, to understand the origins of the data, because then you can assist your legal team and make sure the value of the business at issue is fairly calculated.
In addition to determining the cap rate, the evaluator also must determine the net yearly income of the business. Once the evaluator has determined both the cap rate and the net income of the business, the evaluator plugs both numbers into a formula to calculate the value of the business. To illustrate how the formula work, here’s an example:
Say you have a cap rate of twenty-five percent (25%) based on the four factors outlined above. To figure out the cap rate multiplier, you must determine how many times the cap rate goes into 100. Using our example cap rate of 25%, you know that twenty-five goes into 100 four times. (Twenty-five times four equals 100.) That means that the multiplier for a 25% cap rate is four.
Once you have the multiplier for the cap rate, then you can determine the value of the business one of two ways. Either you can multiply the business’ yearly net income by the multiplier OR you can divide the business’ yearly net income by the percentage cap rate. Again, using our example, if your business earns a net income of $100,000 per year, then you can either divide that number by percentage cap rate (25%) OR multiply it by the multiplier (4). Regardless of which method you use, you get $400,000 as the value of the business.
To demonstrate the same formula again, using different numbers, let’s say that you had determined that your cap rate was only 5%. To determine the multiplier you figure out that 5 goes into 100 twenty times. Thus, your multiplier is 20. Using either calculation method from above, you will determine that the value of a business with a yearly net income of $100,000 would be $1,000,000.
In short, understanding the way a cap rate is calculated can assist you in understanding the way your business is valued and can remove some of the confusion and mystery that is often part of the process. I have oversimplified many of these definitions and explanations, but the brief overview provides a rudimentary understanding of business evaluations. An actual valuation by an expert will be much more comprehensive.
Therefore, if your divorce involves a business, get a jump start on the valuation process by gathering as much information as possible: tax returns, profit and loss statements, bank account statements, etc. That way, you may be able to complete the preliminary work for your attorney. Additionally, gathering information will assist you in determining an approximate value of the business so that you can then decide whether you should invest funds in a formal business appraisal by an expert.