A Business Valuation Perspective on Capitalization Rates & Discount Rates

You stare at the valuation spreadsheet, pondering the intertwined mysteries of capitalization rates and discount rates. As an investor, you know your required rate of return depends on the riskiness of the investment. The riskier the investment, the higher the discount rate you demand. But how do you determine the appropriate discount rate for a private company with no publicly traded equity or debt? The capitalization rate, which you can back out from pricing multiples of comparable public companies, provides a clue.

The rationale behind matching the discount rate to the appropriate measure of economic income is that this earnings basis corresponds to the equity discount rate derived from the build-up, or CAPM, models. The returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. With this insight, you gain confidence in your ability to value private companies. The secrets of capitalization rates and discount rates, while still complex, become more transparent.

Understanding Capitalization Rates in Business Valuation

Understanding capitalization rates is key to business valuation. Capitalization rates, or “cap rates,” represent the rate of return that a business generates relative to its total value. They are calculated by dividing a business’s operating income by its total value.

As an investor, the cap rate helps determine whether an investment in a business will generate an acceptable rate of return. If the cap rate is higher than your required rate of return, the investment may be attractive. Conversely, a low cap rate means the business is highly valued relative to its income, so the investment is likely riskier.

There are three main factors that influence a business’s cap rate:

  1. Interest rates: As interest rates rise, investors require higher returns, so cap rates also increase. When rates fall, cap rates decrease.

  2. Risk: Riskier businesses have higher cap rates, as investors demand greater returns to compensate for the additional risk. Stable, established businesses tend to have lower cap rates.

  3. Growth: Rapidly growing companies often have lower cap rates, as investors anticipate higher future profits and income. Slow-growth businesses typically have higher cap rates due to limited income potential.

In summary, cap rates provide a useful measure of a business’s income relative to its total value. By understanding the factors that influence cap rates, investors can determine whether a business is potentially overvalued or undervalued, and if the potential returns justify the risks. With this knowledge, you’ll be well on your way to making sound business valuation decisions.

What Is the Discount Rate and How Is It Determined?

The discount rate represents the opportunity cost of funds for a company and reflects the rate of return investors can earn on other investments of equivalent risk. As an investor, the discount rate you use in a valuation depends on how risky you perceive the cash flows from the business or investment to be.

  • Riskier investments, with higher uncertainty about future cash flows, require higher discount rates, often 8-15% or more.

  • Safer investments, where cash flows are more predictable, can use lower discount rates, 5-8% typically.

How do you determine the right discount rate to use in a valuation? There are several approaches:

Build-up Approach

The build-up approach starts with a risk-free rate (like the 10-year treasury bond rate) and adds to it risk premiums for equity risk, size, country risk etc. to arrive at a cost of equity. Adding the after-tax cost of debt based on a company’s debt ratio results in the weighted average cost of capital (WACC), which is the discount rate.

Capital Asset Pricing Model (CAPM)

The CAPM approach relates the discount rate to the riskiness of an investment relative to the overall market. It uses the risk-free rate, the beta of the investment (measuring market risk) and the equity risk premium (the extra return investors demand for investing in stocks) to estimate the cost of equity. Like the build-up model, it can be used to get to a WACC.

Surveys and Industry Data

Some investors use surveys of industry experts and industry-level data on costs of capital to determine appropriate discount rates to use in their valuations. The rationale is that these surveys aggregate expert judgments on risk and required returns for industries and sectors.

Using an approach that matches how risky the cash flows from your investment or business look, relative to other investments, should yield a reasonable discount rate to use in your valuation models. Pick a rate that feels right given what you know about the company and how exposed it is to market ups and downs.

The Relationship Between Capitalization Rates and Discount Rates

The relationship between capitalization rates and discount rates is a fundamental one in valuation. Capitalization rates are used to convert cash flows into asset values, while discount rates are employed to determine the present value of future cash flows.

While they seem interchangeable, there are key differences:

  • Capitalization rates are derived from the market prices of comparable assets, reflecting the growth and risk characteristics of the asset being valued. Discount rates start with a riskless rate and build up risk premiums for equity risk, business risk, and asset-specific risk.

  • Capitalization rates are tailored to the specific asset being valued, whereas discount rates can be used across all investments in a business.

  • Capitalization rates represent the rate of return expected in the next period, allowing for no growth. Discount rates allow for compounded growth over multiple time periods.

The rationale behind matching the discount rate to the appropriate measure of economic income is that this earnings basis corresponds to the equity discount rate derived from the build-up models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows.

While there are many views on the relationship between capitalization rates and discount rates, the consensus is that:

  • For stable, mature businesses with little growth, capitalization rates and discount rates will be similar.

  • For high-growth businesses, discount rates will be higher than capitalization rates to reflect the higher risk.

  • The differential will depend on the business risk and growth characteristics of the business being valued. Higher risk and more growth potential imply a larger difference between the two rates.

In the end, both capitalization rates and discount rates attempt to relate income and value for businesses, with the differences reflecting their place in the valuation process. Used judiciously, they provide valuable information for analysts and investors.

Best Practices for Selecting the Appropriate Rates

When estimating the cost of equity for a business valuation, it is important to choose discount rates and capitalization rates that match the nature of the cash flows being discounted or capitalized. The rationale behind matching the discount rate to the appropriate measure of economic income is that this earnings basis corresponds to the equity discount rate derived from the build-up, or CAPM, models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows.

Best Practices for Selecting the Appropriate Rates

  1. For discounting free cash flows to equity, use the cost of equity: The free cash flows to equity represent the cash flows available to equity investors after meeting all operating needs and investment requirements. Since these cash flows accrue entirely to equity investors, the appropriate discount rate is the cost of equity.

  2. For discounting net income, use the weighted average cost of capital: Since net income is generated using both debt and equity capital, the appropriate discount rate is the weighted average cost of capital, which reflects the cost of both debt and equity financing.

  3. For capitalizing net operating income, use the weighted average cost of capital: Like net income, net operating income is also generated using both debt and equity capital. Therefore, the weighted average cost of capital is the appropriate rate for capitalizing net operating income.

  4. Adjust discount rates for different levels of risk: The discount rate used should be consistent with the riskiness of the future cash flows. More uncertain cash flows require higher discount rates to compensate investors for the higher risk. Cash flows from stable, mature companies are less risky and call for lower discount rates.

  5. Avoid overly aggressive discount rates: While higher discount rates produce lower business valuations, unrealistically high discount rates should be avoided. Rates that far exceed the cost of capital for comparable companies in the same industry may not be credible. Selecting reasonable discount rates supported by data and analysis is the prudent approach.

 

Common Errors and Misconceptions to Avoid With Discount Rates

A common error in estimating discount rates is using a single rate for all cash flows, regardless of risk. The rationale behind matching discount rates to cash flow is that each cash flow stream has a different risk profile. Using a single rate ignores these differences and can lead to flawed valuations.

Mismatching cash flows and discount rates

The riskier the cash flow, the higher the discount rate that should be applied. If stable cash flows are discounted at a high rate, the valuation will be too low. If risky cash flows are discounted at a low rate, the valuation will be too high. It is important to match the riskiness of the cash flows to the discount rate.

Using the wrong risk-free rate

The risk-free rate is the foundation for building up discount rates in the CAPM framework. If an inappropriate risk-free rate is used, it will lead to an incorrect discount rate and valuation. For US valuations, the 10-year Treasury bond rate is typically used. For international valuations, government bond rates from that country are used.

Assuming beta is constant

Beta measures the sensitivity of a stock’s returns to the overall market. Betas change over time and should not be assumed constant. Historical betas provide a reference point but forward-looking betas that incorporate expected changes in business risk are more appropriate for valuation.

Not adjusting for private company risk

The betas of publicly traded companies are more readily available but private company betas need to be adjusted upwards for illiquidity and other risks. Not making this adjustment will lead to discount rates that are too low and valuations that are too high.

Using nominal instead of real cash flows and rates

For longer-term valuations, it is important to distinguish between real and nominal cash flows. Nominal cash flows include the effect of inflation whereas real cash flows exclude it. If nominal cash flows and rates are used, it will overstate the value of the cash flows and the valuation. Real cash flows should be discounted at real rates.

Applying rigor and discipline when estimating discount rates is key to getting valuations right. Avoiding these common errors and misconceptions will lead to more precise valuations. Matching the riskiness of the cash flows with the appropriate discount rate is the goal.

Conclusion

As an investor, you have to make a choice between valuing a business based upon its cash flows or earnings. Valuing based on earnings opens you up to the possibility that the earnings numbers have been manipulated for effect, giving you an unrealistic sense of what the business can generate as cash flows. With cash flows, there is less room for accounting legerdemain and a much better sense of what the business can generate in capital for expansion and debt payments. The rationale behind matching the discount rate to the appropriate measure of economic income is that this earnings basis corresponds to the equity discount rate derived from the build-up, or CAPM, models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. When valuing businesses, you have to choose wisely between earnings and cash flows, pick your discount rates to match, and be wary of earnings numbers that seem too good to be true.

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President & CEO

Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.

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