Capitalization Rate and Stocks

In real estate investing, real estate investors use a certain metric called Capitalization or Cap rate. When this rate goes below a certain designated value, the real estate investor decides to sell his property. A metric that tells you when to sell, and do so profitably. How neat. And how do you wish that there was a similar metric you can use for stocks, and tell you when to sell.

Good news is, there is, and we've known it all along if you read my previous posts. Capitalization or Cap rate simply measures the net operating income of the property (excluding interest mortgage payments) in relation to the current value of the property. The Cap rate focuses on the income generation capacity (operating income) of the property itself, and excludes external factors like financing costs or mortgage interest payments.

In simple terms, cap rate is the money coming in relation to the current value of the asset, focusing only on the income generating capacity of the asset, and excluding external factors that may affect the returns of the asset.

Money coming in.. If we think about stocks, we can compare this to net income. We can also compare this to dividend rate. Net income (P/E ratio) and dividend rates are also both metrics that measure income in relation to the value or current market price of the asset. But between net income and dividend rate, the one that really comes to you as tangible returns or money is the dividend rate. Hence, because of this reason, we will choose to compare the capitalization rate to the dividend rate.

I mentioned earlier that when the capitalization rate falls below a certain value, real estate investors sell their property. This value is usually the interest rate on the mortgage of the property. The capitalization rate (income rate) is directly compared with the interest rate (expense rate). When the income rate goes below the interest rate, it means you are already losing money or negative gearing.

However, remember that the capitalization rate is a percentage which also takes into account the current market value of the property. If the net operating income on the property stays the same, but the market value of the company doubles, the effect of this on the capitalization rate percentage is to go down. Since the denominator (current market value) is doubled, and the numerator (net operating income) remains the same, the percentage or capitalization rate is halved. 

Since the capitalization rate has halved or decreased, it may have fallen below the designated value or the interest (expense) rate, and the real estate investor decides to sell. Why would he do that, even if the net operating income of the property remained the same? Well remember that even if the net operating income stayed the same as before, the cap rate still went down because the market value of the property doubled. This means that if the real estate investor sold now, he still sells at a profit, because this time, the market value has increased instead of the net operating income. He realizes his capital gains on the property.

Applying these principles to stocks, we have earlier chosen the dividend rate as the most suitable equivalent of capitalization rate in equities. Now, as the stock investor decided then, at which value should he peg the dividend rate, so when the dividend rate goes below it, he will decide to sell.

Well, since the stock investor deals directly im currency, one external factor that I can think of that can diminish the returns on your stock is the inflation rate.

Hence, you can buy stocks that have dividend rates above the inflation rate. It means that regardless of the capital gains on the stock, you are making money on dividends as you are making it over the inflation rate. You can sell when the dividend rate goes below the inflation rate. This means that the stock has decreased its profit, and therefore decreased dividend income, OR the stock has doubled in market value, or capital gains, that if you sold now, you would realize a hedty capital gains profit.

And voila, we have just made more insight into the dividend rate, and made it more valuable by comparing it to the capitalization rate. Dividend rate is one of my 3 most important metrics for gauging the value of the stock, with the other two being P/E ratio and Price to Book Value.

I have also recently added two safety values or metrics which helps gauge the stocks safety, when it comes to solvency, the current ratio and the interest rate coverage.

Remember, these are only financial ratios or metrics, and you must also use your qualitative judgement, your knowledge of the brand as a consumer and from word of mouth, your impressions of its products and services.