Capitalisation rate: pricing a business the way you price a building

Where it comes from

Property investors have a habit worth stealing: they price a building on what it collects, not on what it might be worth to someone else later. A house bought for 1,000 that nets 50 a year in rent after costs has a capitalisation rate of 5%.

capitalisation rate = annual net income ÷ price paid

50 ÷ 1,000 = 5%. The same house at 800 yields 6.25%; at 1,200 it yields 4.17%.

The rent did not change. Only the price did. The yield is not a property of the building — it is a property of the deal you made.

A share of a company is the same kind of object: an asset that generates cash, where the only lever you control is what you pay for it. So the transfer is direct — replace rent with the cash the business can actually distribute, and the arithmetic is unchanged.

Rent, and the equivalent of rent

A landlord deducts the roof repair and does not deduct the new storey. Both are spending on the building; only one of them was required to keep collecting the same rent next year.

Fixing the leak is maintenance. Skip it and the rent falls. It comes out of the income before you compute a yield.
Adding a storey is growth. Skip it and the rent stays exactly where it was. It is a separate decision about deploying capital, not a cost of the existing income.

Which is why this model runs on owner earnings and not on free cash flow: free cash flow subtracts the extra storey as though it were the leak. Use the figure that reflects maintenance only, and the yield you compute describes the income stream you are actually buying.

Why the required rate is 10%

Property transacts at 4% to 6% in most markets. Demanding 10% from a business is roughly double that, and the gap is not greed — it is three specific differences between the two assets.

A building is collateral; a business is a going concern. If the tenant leaves, the building is still there and still has a floor value. If the customers leave, there may be nothing left to recover.
Rent is contractual; earnings are not. A lease is a document you can enforce. Next year’s operating profit is a hope with a track record attached.
A business can be disrupted in a way a location cannot. The ground a building stands on is not going to be replaced by a cheaper substitute. An industry can be.

Turning the rate into a price

The cap rate formula answers "what yield am I getting?" You want the other direction: "what price gives me the yield I require?" So fix the rate and solve for price.

value = distributable earnings ÷ 10% = distributable earnings × 10

Owner earnings of 200 gives a value of 2,000. At a market price of 1,600 the yield is 12.5%; at 3,000 it is 6.7%.

Multiplying by ten looks like applying a price-to-earnings ratio of 10, and it is worth being clear about why it is not the same thing.

The denominator is different. A P/E multiplies reported net income, which includes non-cash items and one-off gains. This multiplies cash the owner could take out after maintenance.
The direction is different. A P/E is a description of what the market is paying. This is a statement of what you are prepared to pay.
The reasoning is different. A P/E of 10 is justified by comparison to other companies’ multiples. A 10% yield is justified by what you require from the capital, regardless of what anyone else is accepting.

Two blind spots

The model’s strength is that it forecasts nothing. That is also precisely its weakness, and the weakness is asymmetric.

On a growing business it is conservative, and that is fine. A company compounding at 12% is worth more than ten times today’s cash, so the model hands you a floor. A floor you can live with.
On a declining business it is optimistic, and that is not fine. The model takes this year’s cash and extends it to the horizon. If the cash is structurally falling, you have just capitalised a number that will not be there next year — and because the stock looks cheap on the way down, the model actively points you into the trap.

Without a moat, a cap-rate value is a cheque written against an account you have not checked.

Which puts the model in its place. The arithmetic takes two minutes; it borrows all of its validity from the work you did before you opened it — the ten years of ROIC, the four growth rates, the reason competitors cannot take this income away. Done in that order it is a useful floor. Done first, it is a number.