If you are valuing a small business, you have run across the need to establish the discount rate. You do this as part of risk assessment, a key element in any business valuation. In addition to the well known Build-Up model, you also have the capital asset pricing model, or CAPM, to calculate the discount rates.
Financial analysts have used the CAPM for decades to value publicly traded companies. One new element that CAPM introduces is the concept of systematic business risk. If you take a look at the CAPM formula, notice the beta that captures this systematic risk. Beta shows how well the company’s financial returns track the overall equities market.
You calculate beta from the total returns of the company you value. And these returns include two components:
- Rise and fall in the market value of company stock
For public companies, you can easily get at both of these components. Stock prices for these companies are well known. Hence, you can calculate the historic returns and correlate them to the market such as the S & P 500 index returns.
But you face a different situation when valuing a private company. Most likely, you have no way to measure the market value of its stock. Hence, this has created a stumbling block for using the CAPM model in private company valuations.
Still want to use the CAPM in private business valuation? Then you can take a couple of approaches.
Estimating a proxy beta
Let’s imagine the company operates in an industry where public companies compete. Then you can pick a number of guideline companies for your analysis. Now calculate the beta for your target private firm by establishing a statistical composite, such as the median beta for the industry group. If your company closely resembles the guideline firms used in the calculation, you can argue that the beta estimate is valid.
Note, however, that the proxy beta is based on returns of other companies, rather than the firm being valued. It may be a close approximation of the real figure, but falls short of the direct factor calculation as is done for public companies.
In some industries dominated by private businesses, there may not be enough guideline company data to run such proxy beta calculations.
Using results of business valuation directly
You can use other valuation methods to estimate the market value of the company. An example would be the market based valuations or the multiple of discretionary earnings method. These methods are well suited for private company valuation and do not require that you calculate the discount rate.
You can run a number of such preliminary valuations, estimate the market value of the company’s stock, and use the results to calculate the company’s beta. Once the beta is known, you can refine your business valuation by applying other methods such as the discounted cash flow that require the discount rate as one of the inputs.
The Build-Up model works for private company valuation
You can always resort to the Build-Up model to calculate your discount rate. This model depends on the data you can get from the public capital markets. In other words, you do not need to estimate the beta to build up your discount rate.