Even in business valuation world, some people describe a discount rate and a capitalization rate as separate concepts; others use the terms interchangeably. I would just say that both concepts are the result of the build-up method in valuation.

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That means a valuation professional uses a variety of factors (hard numbers as well as judgment calls based on industry research) to build up a variety of numbers and reach a critical piece of information: whether it’s smarter for a potential buyer to sock her funds in this business or simply invest the money elsewhere.

In the context of business valuation, a discount rate gives that answer before certain tax, cost-of-capital, and cash-flow adjustments are made. The capitalization rate is the final measurement that comes after those final adjustments.

The discount rate can alternatively be called a required rate of return (what you’re expecting the investment to yield), considering how risky it is. As such, it’s essentially a measure of the risk of an investment. It’s determined by building risk factor on risk factor until you?ve considered all the potential risks in an investment.

 

What Kind Of Numbers Go Into Calculating A Discount Rate?

A valuation professional builds up a discount rate by starting out with a risk-free rate (usually the T-bill rate) and gradually building risk factors onto the risk-free rate until all the risk factors related to the business being valued have been taken into account. Here’s how it works:

1. The first addition is a market risk premium over the risk-free rate, to bring the rate to what can be expected from an investment in a publicly traded company (with average industry risk).

2. The second adjustment is an adjustment for industry risk (some industries trade at a higher market risk premium than others because of industry risk).

3. The next risk premium relates to the size of the business.

4. Thereafter, the valuation professional adds or deducts premiums for company-specific information that was uncovered during the analysis of the business.

Consider an example of how the resultant discount rate is used. You have a business in your sights that you want to invest in and you know that your annual return from this business will be $100,000. You do some research and figure out that 33 percent is a standard capitalization rate for other businesses this size that operate in the same industry, that 33 percent is your capitalization rate here. So you do the math:

$100,000 / 0.33 = $300,000

That $300,000 is the actual value of the investment. Should you pay $300,000 for that business? See whether you can get it for less.

When determining discount and capitalization rates, you have the option to use either the build-up method or the capital asset pricing model (CAPM) method. (We get to those methods shortly.) If you’re valuing the company on a debt-free basis, you can convert the discount and capitalization rates to their debt-free equivalents based on the company’s weighted average cost of capital.

Next, we are talking about the most common income valuation methods.

 

Capitalization of Earnings Method

The Capitalization of Earnings Method reflects the previous calculation: It takes an earnings number from a particular period and computes the value of the entire investment when divided by a particular capitalization rate. Here’s the formula:

IBDIT / Cap Rate = Value

Note:

This basic method determines the value of a business’s capital asset pricing and your strategy for negotiation. However, keep in mind that this method assumes that the business will grow at a stable rate every year or won’t grow at all.

 

Discounted Cash Flow (DCF) Method

The DCF Method calculates the present value of future expected cash flows using a selected discount rate. People usually use it when a company?s earnings growth is different from year to year (the company may be growing exponentially, or it may be unstable for a variety of reasons, good or bad).

DCF analysis is usually applied to companies that are rather young or companies that are experiencing high growth. (Note that young businesses that are still experiencing variable growth may also be more risky.)

Each of the company’s individual cash flows is discounted to a present value by using a discount rate over a discrete number of periods. At the end of the period, usually when it’s assumed that the company’s earnings have stabilized, a terminal value is calculated by using a capitalization rate. All the various values are summed to arrive at an overall value of the cash-flow stream.

Management of the business to be valued should provide the future cash flows and the assumptions they’re based on, and the valuation professional should carefully and critically assess them. If you’re assessing your own business, make every attempt to approach the process with a good dose of realism.

Here’s the DCF formula:

DCF = CF0 – the sum of [(1 + g) / (1 + r) x]

Note:

  • x = 0 to n
  • DCF = discounted cash flow
  • CF0 = today’s cash flow
  • g = expected growth
  • r = expected rate of return
  • n = number of periods (which is usually not more than three to five years)

However, you’re not done yet. What you’ve done so far with the discounted cash flow doesn’t include the prospects of the business after the discrete period years, and you sincerely hope that the business will continue on into the future. At this point, you need to make an educated guess regarding what may be expected as a long-term growth rate into the future and then use this information to determine the terminal value at that time. The terminal value can be determined by using the Gordon Growth Model, as follows:

Price = I / (R – g)

Note:

  • I = annual cash flow at the end of the discrete period
  • R =risk or the discount rate
  • g = constant growth rate into perpetuity

This calculation gets you to something called a terminal value at the end of a period when the company’s growth rate is expected to become stable.

Consider the methodology examples you see here as the most common, but realize that many more techniques can reach valuation conclusions based on particular industries and situations. In many valuations, you see a professional use more than one approach and methods within that approach to test valuation from a number of perspectives.

 

Weighted Average Cost of Capital (WACC) Method

The WACC Method can help a company calculate the cost of raising money. The calculation involves multiplying the cost of each element of capital, such as debt (loans and bonds) and equity (common stock and preferred stock) by its percentage of the total capital and then adding them together. The final figure, the weighted average cost of capital (WACC), is a rough guide to the rate of required return per monetary unit of capital.

Take a look at the formula:

WACC = [Ke + Kd(D/E)] / [1 + (D/E)]

Note:

  • Ke = desired return on equity
  • Kd = desired return on debt
  • D/E = debt/equity ratio

 

Excess Earnings Method

We?re not exactly in love with the Excess Earnings Method. In fact, some people like to call it the Etch A Sketch Method. This method gets a lot of attention for the valuation of companies with significant intangible assets, but it’s also earned a fair amount of controversy. Here’s how it works:

1. The market value of net tangible assets is multiplied by a rate of return appropriate to these assets to calculate earnings attributable to tangible assets. Net tangible assets are calculated first, and then an assumption is made about whether those tangible assets should provide at least a basic return on investment, such as 10 to 15 percent.

2. This earnings figure is deducted from total earnings to calculate an earnings figure attributable to intangible assets. After that return is calculated, the difference between that return and the company?s actual cash flow is the amount of cash flow attributable to intangibles.

3. These intangible earnings are divided by a capitalization rate for intangibles to calculate an estimated value for the intangibles.

You now have the value of the intangibles in very, very rough terms at least.

A lot of potential for inaccuracy arises with the Excess Earnings Method, particularly among neophytes. The level of subjectivity is very wide. What rate should a net tangible asset return ? 10, 15, or 20 percent? A delivery truck has a different expected contribution than a piece of machinery on the plant floor, and depending on which one you pick, it has either less or more of an impact on the intangible calculation. A question also arises over what capitalization rate to use for intangible assets, and most people place that rate at a high level.

The IRS developed the Excess Earnings Method during Prohibition to compensate distilleries for putting them out of business during the Volstead Act. More sophisticated techniques have evolved since then.?So why use it? A lot of people love this method because it’s a relatively easy one to do. But leave it to the IRS to be a wet blanket: The agency once thought the method was okay to use, but now it denounces it because depending on the calculation, some firms can create much more value than they’re entitled to. Yet some people are still attracted to this method when they?re reporting higher earnings than they normally do.

Back to the capitalization rate. When you hear the term capitalization of income, it’s the way the economic worth of a company is estimated by computing the present value of average annual net income that the company is expected to produce in the future.

Projecting future income isn’t just a matter of numbers, it involves applying certain assumptions about the risk and reward of a particular business investment. As you see in the preceding computation, a cap rate requires research and comparison with other similar companies ?(but the computation works for stock investments, machinery, or any asset).

Another way to explain the capitalization rate is as the yield necessary to attract investors to a particular investment, given the risks associated with that investment. And in the world of investing in businesses or in securities, the greater the risk, the greater the potential for reward.

What are some of the non-numeric risk factors that get built into capitalization and discount rates that valuation professionals apply? I list a few here:

  • Strong product lines
  • Talented management
  • Strong customer baseDominant market share
  • Great financial controls
  • Low employee turnover (and for some valuations, no unions are a plus)
  • No hidden liabilities that may blow up into expensive lawsuits
  • Financial ratios that exceed other companies in its industry class