What’s in a Discount Rate?

ByKelly Deis

Anytime you are valuing a business, it is important to understand the concept behind the discount rate and how it is applied.

The value of a business is essentially the present value of the stream of future cash flows that the business will most likely generate.

Said another way, the value of a business is equivalent to the lump sum of money that, if the owner were to invest this cash at an appropriate rate of return, would generate the future cash flows that the business is expected to provide.

The “discount rate” is nothing more than the the rate of return of an investment with comparable risk and expected returns. Here is the math of how the discount rate is applied:

Let’s assume a $1,000 investment with an annual rate of return 10%. Then, the value of the investment next year is $1,100:

$1,000 * (1 + 0.10) = $1,100
(today’s value * rate of return = tomorrow’s value)

Now, let’s flip it. If you know that you will receive $1,100 next year and the appropriate discount rate is 10%, then the value of $1,100 tomorrow is $1,000 today:

$1,100/(1+0.10) = $1,000
(tomorrow’s value/discount rate = today’s value)

The math is pretty straight-forward. Agreeing on an appropriate discount rate for a business is a little trickier as there is not an open market of comparable investment vehicles for privately owned companies.

A common way to derive the discount rate is called the “Build-Up Method”. This method adds different risk estimates to “build up” a discount rate. the components in the Build-Up Method include:

  1. Risk Free Rate: The risk-free rate measures the rate of return an investor can earn without taking any additional risk. The 20-year US Treasury Bond or similar proxy is often used as the risk-free rate.
  2. Equity Risk Premium: The equity risk premium represents the risk an investor accepts for investing in large public companies. This risk is measured by taking the average annual returns for large capitalization stocks minus average income returns for long term government bonds.
  3. Size Risk Premium: The size risk premium is an additional risk factor for the size of the business. Empirical evidence shows that the smaller the business, the greater the risk. This risk factor is the average annual returns for small capitalization stocks minus average annual returns for large capitalization stocks.
  4. Industry Specific Risk Premium: The industry specific risk premium is based upon the industry in which the Company operates. Some industries are inherently more risky than others, whether it be to cyclicality, potential litigation or some other factor. The risk premium associated with equity, size and industry can be obtained from data published by Morningstar and/or Duff and Phelps.
  5. Specific Company Risk Premium: The company specific risk premium is based upon Company specific factors, such as financial performance, depth of management, dependence on key personnel, customer concentration, diversification of product line, competitive encroachment, as well as other factors. The specific company risk factor is determined by the valuator based on his/her assessment of the business.

The discount rate is the sum of the five risk factors described above.

If you would like help valuing your business, give me a call. I’d be happy to help.