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. Business appraisers “build” discount rates using a concept known as the Capital Asset Pricing Model (CAPM). We walk through its components using a risk-free rate as a foundation and adding premiums. Using our assumptions, we can then build-up a discount rate.

After looking at the Gordon Model (and the DCF model) and understanding indications of the equity value of a business, we look at levels of earnings on an income statement. We consider how they relate to one another as well as how they convert to indications of value. Understanding the differences is critical so that we apply the right multiples to the appropriate and corresponding measures of earnings.

Business owners like to think they know what their businesses are worth. In most cases, unaided by professional valuation guidance, the typical owner will overvalue his or her business. We all like to think we are the exception, rather than the rule, or at the top of the value scale. It just isn’t so for most businesses. And it doesn’t matter what the owners think. In light of that fact, we consider what things do matter and why business owners should have a solid knowledge of what their business is actually worth.

In the prior post, we introduced the basic valuation equation and Gordon Model. In this post, we move on to Net Cash Flow and calculating a multiple as part of the equity value of a business. Despite the fact that many business owners don’t think of (Net) Cash Flow quite like this, the relationship between depreciation and capital expenditures and and working capital requirements impact value. Moving a step further, we dig into risk and growth, examining how each (and the change of each) impacts value.

The value of private companies, like that of public companies, is based on expectations regarding cash flow, growth and risk. Value is always future-based. There are virtually no external analysts following or even looking at most closely held and family businesses, regardless of their size. Quite large private companies will get attention from their banks and also from investment banks who hope to do business with them in the future. However, other than bank credit analysts who look at loan customer performance, there is little following and virtually no externally imposed management discipline. Value changes for private companies over time and with changes in external and internal conditions, even if no one is watching the change.