Whenever you run across a business appraisal for a privately owned company, the choice of discount and capitalization rates pops up. These parameters let you assess company risk, an essential element of valuing any business.
The income based business valuation requires that you provide an accurate estimate of business earnings along with the discount and capitalization rates reflecting business risk. Given the importance of these parameters, there are a number of well known ways to calculate them. Business appraisers refer to these calculations as cost of capital models.
In the language of business investment, the cost of capital is another way of saying that every company must pay for every dollar of investment it attracts. Investors study business risk and decide what sort of returns they should receive given other investment alternatives they could go with.
In other words, business risk and cost of capital refer to the same concept, described from two different points of view. Investment in a business is risky in that you can lose all or part of it, or not receive the returns you expect. Knowing this, you can rank investment opportunities according to the risk level and demand that the riskier investments promise higher returns. Creditors use similar logic, the higher the business risk, the higher the interest the company must pay on its loans.
The cost of capital then is what the company must pay for attracting and retaining required capital, whether from lenders or investors. Two of the best known models to calculate the cost of capital are the build-up and capital asset pricing model or CAPM for short.
CAPM is very popular to calculate the discount and cap rates for public companies. Their returns are known, so you can calculate the beta, which is just the correlation of the company total returns to the overall equities market.
This is problematic if you need to value a private company whose stock does not sell on the open market. Without reliable knowledge of stock prices you can’t calculate the beta that the CAPM model requires. The only way to estimate the returns needed for beta calculation is to run a number of business valuations over time.
In contrast, the build-up model uses the readily available data from the public capital markets. In addition, you can factor in the company specific element, known as company specific risk premium. Given this simplicity, the build-up model is far more useful when valuing private companies.