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DON'T CONFUSE CAPITALIZATION RATES WITH DISCOUNT RATES
Both
capitalization rates and discount rates are often used in valuing a business, but the distinctions between them can be hard
to grasp. Inexperienced valuators may confuse the two, leading to flawed valuations that could fall apart when challenged
in court. 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 require from a potential investment.
The discount rate is directly related to the level of risk related to the investment. Thus, increased risk will result in
a higher discount rate (expected rate of return). For example, investors might only demand a 7% return on an investment in
a relatively risk-free 20-year U.S. Treasury bond. Yet that same investor would 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.
We use the discount rate 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 a company’s current or historical operations appear representative of its future operations
(assuming a normal growth rate), we may choose to capitalize items of past performance. We 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 is increased by the risk inherent in the business. After considering a multitude
of factors, we reach the result: the rate of return that an investor would require for the subject business. We then divide
the indicator by the capitalization rate and 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.
We use a capitalization rate 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 we then multiply by the single-period benefit stream to derive the value. For example, assuming a company’s
cap rate is 25%, that same cap rate can be restated as a multiplier of 4 (1/.25). Notice that we apply a capitalization rate
to a single benefit stream (earnings or cash flow).
This article touches on just a few of the issues concerning discount
rates and capitalization rates. Yet, many more issues must be addressed when developing these rates. If you have questions
concerning these rates, or any other valuation matter, please call us and we’ll give you our professional response.
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