A discount rate is a rate that an investor would demand in exchange for investing in a similar type of asset with similar risk characteristics. Another way to think about it is to consider a discount rate as an opportunity cost.
In the valuation process, a discount rate is used to convert expected future cash flows or other economic benefits into their present value as of the valuation date. It reflects both the time value of money and the risk associated with receiving those future benefits. All else being equal, a higher discount rate results in a lower value, while a lower discount rate results in a higher value.
The appropriate discount rate depends on the specific valuation. It should be consistent with the type of cash flow or economic benefit being discounted, the facts and market conditions as of the valuation date, and the ownership interest being valued. For an overview of the income approach alongside the market and asset approaches, see business valuation methods.
How Valuation Analysts Define Discount Rate in a Business Valuation
A discount rate represents the return an investor would require for an investment with the timing and risk characteristics of the subject business or ownership interest.
The analysis considers the company, its industry, capital structure, financial performance, and risks reflected in the forecast. The discount rate and projected economic benefits must be evaluated together, because a rate can appear reasonable on its own but still be inappropriate when paired with a benefit stream measured on a different basis.
Cost of Equity vs. WACC
The appropriate discount rate depends on the economic benefit being valued.
Net Cash Flow to Invested Capital (NCFIC) represents cash flow available to all providers of capital, including both debt and equity holders. NCFIC is generally discounted using the weighted average cost of capital (WACC).
Net Cash Flow to Equity (NCFE) represents cash flow available to equity holders after considering the effects of debt financing. NCFE is generally discounted using the cost of equity.
WACC reflects the required returns of both debt and equity capital providers based on their respective weights in the capital structure. The cost of equity reflects the return required by equity investors.
The discount rate should be consistent with the economic benefit being discounted. Using the cost of equity to discount NCFIC, or WACC to discount NCFE, would mismatch the discount rate and benefit stream and may result in an inappropriate indication of value.
How Is a Business Valuation Discount Rate Calculated?
A discount rate may be developed using one or more models and market inputs. When developing a cost of equity, the analysis may consider:
- A risk-free rate
- An equity risk premium
- A size premium, where applicable
- Industry or other risk considerations
- Company-specific risk, where appropriate
The appropriate inputs depend on the assignment and available evidence. Historical performance, customer concentration, management depth, financial condition, access to capital, industry conditions, and the reliability of projections may all be relevant.
When WACC is appropriate, the cost of equity is combined with the after-tax cost of debt using an appropriate capital structure.
Each component of the discount rate should be supported and consistent with the assumptions used in the projected cash flows. Risks already reflected in the forecast should not also be reflected in the discount rate without considering whether doing so would double count the same risk.
Company-Specific Risk and Double Counting
A significant consideration in developing a discount rate is whether a particular risk has already been reflected elsewhere in the valuation.
For example, if projected cash flow has already been reduced to reflect customer concentration, management uncertainty, or another company-specific risk, adding a separate premium for the same risk may count that uncertainty twice.
Conversely, projections that assume strong future performance may require consideration of the risks associated with achieving that performance. The forecast and discount rate should tell a consistent economic story about the same investment.
How the Discount Rate Affects Business Value
In a discounted cash-flow analysis, the discount rate is used to convert projected future cash flows to their present value. The further into the future a cash flow is expected to be received, the greater the effect of the discount rate on its present value. As a result, even relatively small changes in the discount rate can materially affect the concluded value, particularly when a significant portion of the value comes from later forecast periods or the terminal value.
Sensitivity analysis can help demonstrate how value changes as the discount rate or other assumptions change. It does not determine the appropriate rate by itself; rather, it illustrates the relationship between the assumptions and the resulting indication of value.
Discount Rate vs. Capitalization Rate
A discount rate and capitalization rate are related, but they are not interchangeable.
A discount rate is used to convert a series of projected future benefits to present value. A capitalization rate converts a single representative level of economic benefit into an indication of value and is commonly used when earnings or cash flow are expected to grow at a stable rate.
Under a constant-growth model, the relationship is generally expressed as: Capitalization Rate = Discount Rate − Long-Term Growth Rate.
That relationship depends on the discount rate, growth rate, and economic benefit being measured consistently. Applying a capitalization rate to benefits that are expected to change materially, or using a discount rate as though it were a capitalization rate, can produce an inappropriate indication of value.
Valuation Date and Supporting the Discount Rate
A discount rate is developed using information appropriate as of the valuation date. Risk-free rates, equity risk premiums, industry conditions, and other market inputs change over time. When a valuation involves multiple dates, the appropriate inputs should be considered separately for each valuation date.
The support for the rate is also important. The source and date of market inputs and the basis for significant adjustments should be documented so that the relationship between the evidence, assumptions, forecast, and concluded discount rate can be understood and evaluated. Where the rate has to be explained under examination, that is testimony by a CPA expert witness rather than a separate exercise.
Ultimately, a discount rate is one component of an income-approach valuation. The appropriate rate depends on the economic benefit being valued, the risks associated with that benefit, and the facts and circumstances of the particular engagement. Business valuation services describes the firm’s work in valuing businesses and ownership interests.
