YouMaketheCall 141range of 8 to 12%. Consumer products businesses—those selling
foods and detergents, for example—tend to remain more stable dur-
ing perio ds of both boom an dbust an dthus generally warrant a
lower-risk cap rate in the range of, say, 6 to 8%.
In addition to depending on the risk-free rate of interest, an
appropriate cap rate takes into account the rate of economic growth
in the overall economy. During periods of steady economic growth
an din dustry expansion, risks are relatively lower. During economic
downturns, growth is less likely, even steady earnings are less likely,
an dthere is a greater likelihoo dof overall earnings contractions. In
such an environment, risk rises, an dyou shoul dchoose higher cap
rates.
Therefore, the rules of thumb for cap rates have to be set ac-
cording to the risk-free rate, the risks of a particular business, and
those of industry in general. Equally important, we must adjust the
cap rate to allow for future variations. If interest rates rise or the
economy slows, for example, the cap rate will have to be increased,
an dvice versa.
The difficulties in estimating earnings and selecting a cap rate
relate back to your circle of competence. Just as an appreciation of
economic history is essential, knowledge of the operating context is
indispensable for the forecasting exercise. GE, Microsoft, and Am-
azon.com all look exceptionally well managed, with Amazon.com
even scoring some knockout points in the key ratios, though GE and
Microsoft also make money from goo dmanagement.
GE is a money machine, particularly in its capital financing di-
vision. It delivered steady earnings increases throughout nearly all
its 100 years and every year during the last 20. Its diverse businesses
an dlea dership in virtually all of them suggest a reasonable basis for
forecasting continue dstea dy earnings generation in the future,
though that is never free from doubt because of evolving economic
environments. With GE’s distinguished performance, however, a
modest cap rate is perfectly reasonable.
Let’s assume GE warrants a risk premium just above the risk-
free rate—say, 5%—an dapply it to our estimate of average future
earnings of about $4.10. An estimate of GE’s value can be made
simply by dividing the earnings estimate by the cap rate, in other
words, $4.10 divided by .05, which equals $82 per share.
If we took a slightly more aggressive guess about GE’s earnings
prospects, our valuation woul dlook different. Suppose, for example,
we forecast the earnings at $5.00. Still using the cap rate of 5%