One of the more difficult tasks individuals
face in reviewing (deciphering) a professionally
prepared business valuation is understanding
some of the finance jargon within a valuation
report. Two terms found in valuation
reports that seem to cause much confusion are
"discount rate" and "capitalization rate." What
exactly are a discount rate and a capitalization
rate? Is this the same "cap rate" I've seen used
in commercial real estate analysis? How are
these two rates used in obtaining an accurate
value of one's business interest? And when do
we use the capitalization rate versus using the
discount rate?
The goal of this article is to help clear up
the confusion and provide you with an introductory
explanation and discussion of discount
rates and capitalization rates. It is an
overview, if you will, of the concepts and some
of the tools most often used to compute discount
and capitalization rates of your own
business. I say overview because the topic of
calculating discount and capitalization rates
can literally take volumes to completely
explain.
Let's start with a typical book definition of
these two terms. A discount rate represents
the total expected rate of return that you the
investor would demand on the purchase price
of an ownership interest in an asset. The discount
rate is used to derive present value factors
to determine the value of a future or projected
benefit stream. A capitalization rate is
used and is either a divisor or a multiplier and
is applied (divided or multiplied) to net earnings
or cash flow to determine value. Usually
by this point in the explanation of discount
and capitalization rates, readers have turned
their brain off and are reaching for a pillow so
as to take a nap. Can you blame them? Really,
after reading all that mumbo-jumbo you're
probably still asking what the heck these definitions
mean Many times business periodicals,
(such as the Wall Street Journal), seemingly
use these terms interchangeably. At the
end of the day, and to many business owners,
the questions still remain:What is a discount
rate, and how is it any different from a capitalization
rate?
Although capitalization rates and discount
rates are technically not the same, they are
closely related. The theory behind discount
and capitalization rates is quite logical. They
find their basis in the concept of risk and
reward. Let me explain: Based on the price to
be paid for an investment, the rate of return
being offered by an investment must be high
enough to justify taking the risk of purchasing
the investment. Additionally, the return must
be at least equal to the rate of return available
from similar alternative investments. Let me
put it in terms those of us here in Nevada can
understand. It means that if I'm going to bet
on the long shot, I want a payoff with better
odds than the favorite.
To understand either of the two terms, discount
rate or capitalization rate, and their
interrelationship, let's start with defining a discount
rate. In the finance world, the discount
rate is also referred to as the required rate of
return, opportunity cost, or the cost of capital.
For this discussion, and to keep confusion to a
minimum,we will talk in terms of required
rates of return. Hence, discount rate equals
required rate of return.
This required rate of return, also understood
to be the rate that is necessary to attract
capital to an investment, is highly affected by
risk. In other words, the discount rate is driven
by risk, and we all know risk equals uncertainty.
Therefore, the greater the uncertainty
the greater the risk, resulting in a greater rate
of return being required.
This required rate of return the discount
rate is comprised of two main elements.
The first element is the safe rate of
return on secure investments (for example, the
20-year Treasury Bond is considered by many
as being a safe rate) and the second element is
an additional return (known as a premium)
that compensates the investor for the relative
degree of risk, in excess of the safe rate inherent
in the investment. Calculating the premium
consists of factors such as size, as well as
industry factors and factors specific to the
company being valued. Calculating this premium
is complex.
To reiterate, a discount rate is equal to an
investor's required rate of return. Therefore,
the discount rate is equal to the risk-free rate
(i.e. safe rate) plus the premium rate associated
with the risk an investor takes that is above
and beyond that which would be incurred with
a safe investment.
Now that we have the discount rate, you
ask, how do we get the illusive capitalization
rate? Simple,we just take the discount rate
(the calculation of which was discussed above)
and subtract the growth rate. Hence, the capitalization
rate is usually lower than the discount
rate, assuming there exists growth.
Note, although similar in financial concept,
the capitalization rate being described here
and used in the valuation of businesses is not
the same as, and should not be confused with,
the "cap rate" used in the commercial real
estate industry.
So now what? We have a discount rate and
we have a capitalization rate. What do we do
with these things and when do we use one versus
the other in valuing a business? Simply
put, and for our purposes, these rates are used
in applying the income approach to our valuation
analysis. (The income approach is one of
the three standard approaches used by business
valuation professionals in valuing a business.)
The discount rate is used to calculate
the value of a company based on future projected
earnings or cash flow (when reliable
future projections are available) and the capitalization
rate is used to calculate the value of
a company based on historical earnings or
cash flow (when historical information is
being relied upon.)
Clear as mud right? Don't worry, understanding
all the concepts surrounding discount
and capitalization rates is quite complex.
Not only is there confusion in the general
public, but confusion exists among the ranks
of educated professionals (including business
valuation professionals) as well. I hope I've
been able to shed some light on this complex
subject and provide an overview that you can
walk away with and apply as a working knowledge
of some of the basics surrounding discount
and capitalization rates.
Darrin Maddox is a senior analyst for
Meridian Business Advisors in Reno.
Contact him through the company's Web site
at www.mbareno.com.
