A discount rate is a rate that is used to discount, i.e., to convert, expected future benefits into present value. The idea of present value is fairly intuitive: A dollar received today is worth more than a dollar to be received in a month or a year.

Children understand present value concepts almost naturally. If you ask a child if he or she would rather have an ice cream cone today or tomorrow, the response will almost certainly be today. Why is this?

• Most kids want their treats now.
• If they wait until tomorrow, the ice cream might melt, or someone else might get it.
• My kids would take their ice cream now because they knew I might forget, and they would get ice cream tomorrow as well!

In other words, kids understand that there is risk associated with waiting for their ice cream, or future benefits.

Building an Equity Discount Rate for a Business

Business appraisers “build” discount rates using a concept known as the Capital Asset Pricing Model (CAPM). I wrote an article many years ago describing what I called the Adjusted Capital Asset Pricing Model. I also wrote about it in my book, Business Valuation: An Integrated Theory Second Edition (with Travis Harms), as well.

We will labor through a build-up process here, but bear with me. When we start talking about multiples of EBITDA shortly, you will know where they come from. And you won’t have to build them up any more.

The idea of building a discount rate is straightforward. We begin with a risk-free rate and add premiums for varying levels of incremental risk:

• Risk-free rate. We begin the build-up with a return associated with so-called riskless assets, or U.S. Treasury rates. Appraisers usually use a long-term rate like the 20-year Treasury rate as the base, or foundation for the build-up process. As I write, the 20-year Treasury rate is about 2.6%.
• Equity risk premium. We are talking about investing in a risky business, so it is reasonable for investors to demand a premium in return relative to the risk-free rate. The starting point for this premium is called the “equity risk premium,” and it is the expected premium return for large capitalization stocks over the risk-free rate. Different analysts come at this in different ways, but a general consensus at the present time would call for an equity risk premium of about 5.50%.There is a concept called beta, which corresponds to the relative riskiness of public companies. If beta is greater than 1.0, then the expected returns of a company are considered to be relatively riskier than the overall market. For example, if a software company’s beta were 1.2x, then we would multiply that factor times the equity risk premium (1.2 x 5.50%) and the adjusted equity risk premium would be 6.60%.Alternatively, if a food processing company’s beta is 0.8x, it would be considered less risky, and the adjusted equity risk premium would be 4.40% (0.8 x 5.50%).I mention beta because, if you get an appraisal of your business, the appraiser may use the concept. However, now that we’ve touched on it, let’s assume that beta is 1.0x and that the equity risk premium is 5.50%.
• Size premium. Historically, there has been an inverse relationship between size and expected, or required returns. Larger companies are perceived as less risky than smaller companies. For example, if we look at the public markets and rank them by size historically, the returns associated with larger companies are lower than for smaller companies, and the relationship is pretty consistent as we look from the largest public companies to smaller ones.The largest decile, as found in the 2015 Valuation Handbook – Guide to Cost of Capital, has a premium to the pure expected CAPM return of close to zero, while the tenth decile has a premium of about 6.0%.There are many ways that appraisers look at size premiums, but for our purposes, let’s assume that the appropriate size premium is 6.0%. Investors would demand at least this return, in addition to the equity risk premium, to invest in a smaller private company.
• Company specific risk. Sales for the largest company in the tenth decile of public companies totaled $339 million in 2014 according to the referenced publication, or much larger than the great majority of private companies in America. The logic of the build-up continues, suggesting that investors in private companies would demand even higher rates of return, or discount rates.Risks of private companies that might be incremental to the size premium above include key personnel issues (or lack of management capability or depth), absolute (smaller) size, financial structure (leverage), concentrations (related to products, geography, suppliers, or customers), earnings (margins, stability, and predictability), and other risks associated with a particular company.The conclusion for specific company risk is based on the judgment and experience of the appraiser or market participant. Assume for now that the appropriate company specific risk premium is 2.0%

Calculating the Discount Rate

Using the assumptions above, we can show the actual build-up of a discount rate in a table to make clear what we have done.

We have used a build-up method to develop an equity discount rate for use in determinations of Market Value of Equity. This discount rate is applicable to the net income/net cash flow of a business as we defined previously.

I know that many business owners don’t think of their earnings as set out in this chart, but with a bit of background, we will move to the more familiar and broader earnings measures like EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).

Note that the discount rate we developed above is 16.1%, or about 16%, assuming company specific risk of 2%. If company specific risk is 0%, the discount rate would be about 14%. If that risk factor is 6%, the discount rate would be about 20%. This range of assumptions would include many private companies today whose values are as low as the $5-$10 million range and moving into much larger business in the present market environment.

Smaller companies might find that their discount rates would range into the 20% to 30% range, depending on size or riskiness.

So when you hear appraisers or others talking about equity discount rates, or required rates of return, which is another term for discount rate, you now have a good idea where they come from. And maybe we have pegged a range of discount rates that is applicable to your business.

This building up of the equity discount rate, or the r we discussed in the Gordon Model is the first step in understanding where market transactional multiples come from and in understanding how market participants use the discounted cash flow model to assist them in pricing companies.

The second step is in the development of the Weighted Average Cost of Capital (WACC), which is applicable to earnings from all sources of capital, including debt, and not just equity. We turn to the WACC in the next post.

In the meantime, be well!

Chris