What Does Capitalization Factor Mean?
Capitalization factor is the multiple or divisor that is used to convert the income expected from an investment into a value metric. This factor is mostly used to determine the value of a business and is computed as the inverse of a company's expected rate of return.
The most common formula used for deciding the capitalization factor is 1/r or r^(-1). In both cases, r is the expected rate of return that an investor hopes to get by investing in the capital of a business. Using this capitalization factor, it is easy to calculate the value of a business:
Value of the Business = Expected Earnings x Capitalization Factor
Divestopedia Explains Capitalization Factor
Capitalization factor helps an investor to compute the discounted rate of the expected return from that investment after the risk factor has been taken into account. For example, a capitalization factor of 4 does not mean that an investor will get his/her money back in four years, rather it means that the investor can expect a rate of return of 25% every year. This earning is also based on the assumption that the growth rate of the investment is zero or is equal to the inflation rate prevailing at the time of return.
As an example, when the rate of return expected from a business is 25%, then the capitalization factor is 1 / 0.25 = 4. Then if the expected earnings of a company is $5,000,000, its value is $5,000,000 x 4 = $20,000,000.
Though the above formula and its computation is easy, it can get confusing when an investor is trying to understand the real meaning of the capitalization factor.
Capitalization factor also shows the risk associated with an investment. In the case above, a return of 25% indicates that the investment is a relatively risky one.