A cap rate (capitalization rate) is a business or property's annual net operating income divided by its purchase price, expressed as a percentage. It is the inverse of a valuation multiple, a business bought at a 2.7× multiple carries roughly a 37% cap rate.
Worked example
| Line | Value |
|---|---|
| Annual earnings (SDE) | $350,000 |
| Purchase price (2.7× SDE) | $945,000 |
| Cap rate = 350,000 ÷ 945,000 | 37% |
A lower purchase multiple means a higher cap rate, you earn back a larger share of the price each year.
Why it matters when buying a business
Cap rate lets you compare deals of different sizes on one number: the yield on the price you pay. A small business at a 37% cap rate is a far higher return than most passive investments, the trade-off is that it takes work to run. Flip it back to a multiple of SDE or EBITDA to sanity-check what a seller is asking.
