A capitalisation rate turns a single, normalised earnings or cash-flow figure into a value by dividing it by a rate that reflects the return an investor requires for the specific risk that this cash flow keeps coming.
Capitalising a single figure is one of two ways Canadian valuators handle the income-based approach, and which one applies is a choice the Business Development Bank of Canada's guide to valuing a business frames directly: "different earnings-based approaches are used depending on whether earnings are expected to be stable in coming years." Where earnings are stable, a single normalised figure divided by a capitalisation rate stands in for a full multi-year forecast; where they are not, the approach moves to a discounted cash flow instead.
The rate itself is not a published number. It is built from a required rate of return for the specific business, reduced for the growth expected in its earnings, and that required return moves with everything a Chartered Business Valuator weighs when sizing risk — company size, customer concentration, and how much the business depends on its current owner rather than a replaceable management team.
Owner-dependence is a live example of a risk factor a cap rate has to absorb rather than a line item earnings can. Deavo's own description of the problem is blunt: it "rarely shows up as a line item anywhere in the financial statements… the size of the effect depends heavily on the specific industry and how replaceable the owner's role actually is," and the article itself gives no quantified figure for it — which is exactly the kind of risk a higher capitalisation rate, not an earnings adjustment, is built to price.
A business generates $500,000 of stable, normalised annual earnings and a valuator concludes a 22% capitalisation rate is appropriate given the business's size, its reliance on two large customers, and the founder's continued personal involvement in sales (these figures are the worked example's own assumptions, not a published Canadian benchmark). Value = $500,000 ÷ 0.22 = $2,272,727. A larger, better-diversified business with the same $500,000 of earnings but a lower-risk profile might instead carry a 15% rate, producing $500,000 ÷ 0.15 = $3,333,333 — the same earnings, a materially different value, purely because the required rate of return differs.
See also: Discounted cash flow (DCF) · Adjusted EBITDA · Comparable company analysis.
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