Capitalisation rate and return on investment are often confused. Natalie Sirianni explains why you need to know the difference when buying or selling a pharmacy
When calculating the value or likely sale price of your pharmacy, or assessing a pharmacy to buy, the capitalisation rate and return on investment will be critical items to consider.
While often the capitalisation rate for a pharmacy is (incorrectly) called the return on investment (or ROI), it is important to note that they are not the same thing! (Unless of course the capital growth is zero over the life of the investment).
So first, let’s define the capitalisation rate for a pharmacy business.
The capitalisation rate is equal to the adjusted net profit for the pharmacy, or future maintainable earnings, divided by the value or price of the pharmacy. It is used in the valuation of pharmacies when using the capitalisation of future maintainable earnings (FME) methodology.
This technique assumes the income is received into perpetuity (i.e. forever) and that historical results will continue into the foreseeable future. Therefore, the capitalisation rate represents the annual return to the owner of the business, as a percentage of the total purchase price paid for the business (including stock and fixtures).
Return on investment
The Return on Investment (or ROI) on the other hand represents the total return to the owner of the business on their investment. For each type of investment class there are two types of return.
Firstly, you have the annual income (for example, dividends in shares, rent in investment properties and net profit of your pharmacy), and secondly the capital gain.
Return comprises both of these; income plus gains. Therefore, the total Return on Investment is usually higher than the capitalisation rate for pharmacies, given that most pharmacies also achieve capital appreciation.
One other factor that is important to note is that because both capitalisation rates and ROIs are percentage figures, this allows for comparison across pharmacies and businesses of different sizes.
Doing the correct comparison
This is helpful, but again it is important to remember that capitalisation rates and ROIs are different, so make sure you are comparing like with like.
If two pharmacies have the same capitalisation rate, but one has 0% capital growth and the other has 10% capital growth per annum, the total return on investment for the businesses will be very different!
Finally, I note that Return on Investment provides the total return to the business owner and assumes that you pay for your investment in full.
Given that most pharmacy owners borrow the majority of the purchase price from a bank, a more relevant or important measure to look at is the Return on Equity, which essentially measures the return on the actual money you put into your investment.
I will leave Return on Equity to cover in another article.
Natalie Sirianni is Director of Attain Business Services
“If you have any questions about the capitalisation rate or ROI for your pharmacy, please feel free to call me at anytime on 0406 919 860. I look forward to discussing with you further!”