Have you ever had your business appraised, read a business appraisal or heard a business appraiser speak and become confused when the terms discount rate, capitalization rate and multiple are all used in explaining the value of a Company? What exactly is the difference?
Let’s take, for example, a Company that has stable cash flows that are expected to continue at a consistent growth rate into the future. Under the income approach, we would apply what is called the “Capitalization of Cash Flows” method. The first step with this method is to determine the appropriate discount rate for the Company. The discount rate is considered a market rate. It is the rate of return necessary to induce investors to commit available funds to the subject investment, given its level of risk.1 One common method to determine the discount rate, or rate of return that investors require, is the build-up method. This incorporates the following components:
- Risk Free Rate – the rate of return available on a risk free security (i.e. 20-year Treasury Bond yield)
- Equity Risk Premium – the rate of return to reflect the additional risk of investing in the stock market over the risk free security (i.e. S&P 500 stocks)
- Size Premium – the reward for investing in smaller companies
- Specific company risk premium – the reward for investing in a specific company and industry
The sum of each component equals the discount rate. The higher the discount rate the riskier the investment. Let’s assume in our example that the discount rate for the Company is calculated as follows:
|Risk Free Rate||2.54%|
|Equity Risk Premium||6.70%|
|Specific Company Risk Premium||9.00%|
|Discount Rate (or Rate of Return)||24.27%|
The discount rate is indicating that an investor would require a rate of return of 24.27% to invest in the Company. The next step is to calculate the capitalization rate. The capitalization rate is the discount rate less the long-term expected growth rate. This percentage is used to convert anticipated economic benefits of a single period into value. If the expected long term growth rate is 4%, the capitalization rate (rounded) is 20%. If the Company has stabilized annual cash flows of $1,000,000, the estimated value of the Company prior to discounts is $5,000,000 ($1,000,000/.20).
Many people are more familiar and comfortable with using multiples when discussing the value of a Company. A multiple is simply the inverse of the capitalization rate. In this example, the multiple of cash flows is 5 (1/.20). Using the multiple of 5, you arrive at the same value prior to discounts of $5,000,000 ($1,000,000 x 5).
Hopefully this simple example provides some clarity when dealing with discount rates, capitalization rates and multiples in a business valuation context.