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Understanding capitalization and discount rates in business

Darrin Maddox

One of the more difficult tasks individuals

face in reviewing (deciphering) a professionally

prepared business valuation is understanding

some of the finance jargon within a valuation

report. Two terms found in valuation

reports that seem to cause much confusion are

“discount rate” and “capitalization rate.” What

exactly are a discount rate and a capitalization

rate? Is this the same “cap rate” I’ve seen used

in commercial real estate analysis? How are

these two rates used in obtaining an accurate

value of one’s business interest? And when do

we use the capitalization rate versus using the

discount rate?

The goal of this article is to help clear up

the confusion and provide you with an introductory

explanation and discussion of discount

rates and capitalization rates. It is an

overview, if you will, of the concepts and some

of the tools most often used to compute discount

and capitalization rates of your own

business. I say overview because the topic of

calculating discount and capitalization rates

can literally take volumes to completely

explain.

Let’s start with a typical book definition of

these two terms. A discount rate represents

the total expected rate of return that you the

investor would demand on the purchase price

of an ownership interest in an asset. The discount

rate is used to derive present value factors

to determine the value of a future or projected

benefit stream. A capitalization rate is

used and is either a divisor or a multiplier and

is applied (divided or multiplied) to net earnings

or cash flow to determine value. Usually

by this point in the explanation of discount

and capitalization rates, readers have turned

their brain off and are reaching for a pillow so

as to take a nap. Can you blame them? Really,

after reading all that mumbo-jumbo you’re

probably still asking what the heck these definitions

mean Many times business periodicals,

(such as the Wall Street Journal), seemingly

use these terms interchangeably. At the

end of the day, and to many business owners,

the questions still remain:What is a discount

rate, and how is it any different from a capitalization

rate?

Although capitalization rates and discount

rates are technically not the same, they are

closely related. The theory behind discount

and capitalization rates is quite logical. They

find their basis in the concept of risk and

reward. Let me explain: Based on the price to

be paid for an investment, the rate of return

being offered by an investment must be high

enough to justify taking the risk of purchasing

the investment. Additionally, the return must

be at least equal to the rate of return available

from similar alternative investments. Let me

put it in terms those of us here in Nevada can

understand. It means that if I’m going to bet

on the long shot, I want a payoff with better

odds than the favorite.

To understand either of the two terms, discount

rate or capitalization rate, and their

interrelationship, let’s start with defining a discount

rate. In the finance world, the discount

rate is also referred to as the required rate of

return, opportunity cost, or the cost of capital.

For this discussion, and to keep confusion to a

minimum,we will talk in terms of required

rates of return. Hence, discount rate equals

required rate of return.

This required rate of return, also understood

to be the rate that is necessary to attract

capital to an investment, is highly affected by

risk. In other words, the discount rate is driven

by risk, and we all know risk equals uncertainty.

Therefore, the greater the uncertainty

the greater the risk, resulting in a greater rate

of return being required.

This required rate of return the discount

rate is comprised of two main elements.

The first element is the safe rate of

return on secure investments (for example, the

20-year Treasury Bond is considered by many

as being a safe rate) and the second element is

an additional return (known as a premium)

that compensates the investor for the relative

degree of risk, in excess of the safe rate inherent

in the investment. Calculating the premium

consists of factors such as size, as well as

industry factors and factors specific to the

company being valued. Calculating this premium

is complex.

To reiterate, a discount rate is equal to an

investor’s required rate of return. Therefore,

the discount rate is equal to the risk-free rate

(i.e. safe rate) plus the premium rate associated

with the risk an investor takes that is above

and beyond that which would be incurred with

a safe investment.

Now that we have the discount rate, you

ask, how do we get the illusive capitalization

rate? Simple,we just take the discount rate

(the calculation of which was discussed above)

and subtract the growth rate. Hence, the capitalization

rate is usually lower than the discount

rate, assuming there exists growth.

Note, although similar in financial concept,

the capitalization rate being described here

and used in the valuation of businesses is not

the same as, and should not be confused with,

the “cap rate” used in the commercial real

estate industry.

So now what? We have a discount rate and

we have a capitalization rate. What do we do

with these things and when do we use one versus

the other in valuing a business? Simply

put, and for our purposes, these rates are used

in applying the income approach to our valuation

analysis. (The income approach is one of

the three standard approaches used by business

valuation professionals in valuing a business.)

The discount rate is used to calculate

the value of a company based on future projected

earnings or cash flow (when reliable

future projections are available) and the capitalization

rate is used to calculate the value of

a company based on historical earnings or

cash flow (when historical information is

being relied upon.)

Clear as mud right? Don’t worry, understanding

all the concepts surrounding discount

and capitalization rates is quite complex.

Not only is there confusion in the general

public, but confusion exists among the ranks

of educated professionals (including business

valuation professionals) as well. I hope I’ve

been able to shed some light on this complex

subject and provide an overview that you can

walk away with and apply as a working knowledge

of some of the basics surrounding discount

and capitalization rates.

Darrin Maddox is a senior analyst for

Meridian Business Advisors in Reno.

Contact him through the company’s Web site

at http://www.mbareno.com.