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June 2007 Capitalization rates vs. discount rates In calculating business value, the proper application of either rate should produce an accurate result In valuing a business, valuation professionals often use both discount rates and capitalization rates. It is easy to confuse one with the other, and the differences between them can be hard to discern. Let’s review some characteristics of the two rates to see how they differ. Discount Rate. In valuation theory, a discount rate represents the total expected rate of return that an investor would likely require from a potential investment. The discount rate is directly related to the level of risk; thus, increased risk will result in a higher discount rate. For example, an investor might demand only a 7% return on an investment in a relatively risk-free 20-year U.S. Treasury bond. At the same time, that investor would probably demand a much higher rate of return, say 30%, on an investment in an equity interest in a closely held company with considerably more risk. Quantifying the level of risk is where the challenge lies in developing discount rates. Some components of the discount rate can be easily quantified, such as the risk-free rate. Other components, such as industry risk and company-specific risk, are more qualitative and require a high level of judgment to realistically quantify. An experienced valuator can identify the factors related to such risk and begin to quantify them. The discount rate is generally used to derive the present value factors that are used to discount a future benefit stream, such as earnings or cash flow for multiple periods, to a present value. To apply the appropriate discount rate to the correct benefit stream is vital. Capitalization Rate. If projections of future earnings or cash flows are not available, or if a company’s current or historical operations appear representative of its future operations (assuming a normal growth rate), the valuation professional may choose to capitalize items of past performance. Experienced valuators generally select earnings before tax, operating income, cash flow or some other measurable quantity, and then build a suitable capitalization rate. This rate includes the risk-free rate of return as its core, and it is increased by the risk inherent in the business. After considering a multitude of factors, the valuator reaches the result: the rate of return that an investor would require for the subject business. The indicator is then divided by the capitalization rate to determine a value. A company’s capitalization rate is often derived by subtracting a company’s expected long-term annual growth rate from its discount rate. Thus, a growing company’s capitalization rate is usually lower than its discount rate. A capitalization rate is used as a divisor or a multiplier to determine the value of a single-period benefit stream (earnings or cash flow). When stated as a percentage, the capitalization rate is divided into the benefit stream to determine a company’s value. The reciprocal of the capitalization percentage becomes a multiplier, which is then multiplied by the single-period benefit stream to derive the value. Two Rates, One Purpose. If a valuator uses the correct assumptions, he or she should arrive at essentially the same value, whether using the discounted cash flow approach or the capitalization of earnings method. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
