Business valuation: how discount and capitalization rates are related

Take a look at a typical business valuation and you will see a discussion of discount and capitalization rates. These are often confused with each other, usually because capitalization is a special form of discounting in valuation.

Capitalization of business earnings is very common. The idea is to use the expected economic benefit for a single time period, usually a net cash flow projected for a year right after the date of business appraisal. Going forward, the business cash flow is expected to change at a constant rate year over year.

If this constant earnings growth assumption is not realistic for your company, you should use the discounting technique in your valuation. In such situations, you project business earnings for a number of years and apply the discount rate to determine the business present value, or what is is worth today.

The advantage of discounting is that it lets you determine the value of a company whose earnings are not constant and do not change at a fixed rate over time.

Beyond a certain point in time, the accuracy of your forecast diminishes. A typical way to handle this lack of certainty is to assume that business earnings would change at a sustainable constant growth rate in perpetuity. Hence, the business value is the sum of the discounted earnings forecast and the capitalized residual value beyond the forecast horizon.

Unsurprisingly, the discount and capitalization rates are closely related:

Capitalization rate = Discount rate – Expected earnings growth rate

Note that the discount and capitalization rates become equal if business earnings don’t grow.

Valuing businesses by direct capitalization is very popular because it is so simple. All you have to do is estimate the net cash flows for a single year, and then apply the capitalization rate to calculate the value. While the discounting is a more general way to value a business, it requires that you estimate a set of business earnings for a period of time, say 5 – 10 years into the future, and then use the discounting method to calculate your value result.

Your business valuation is as accurate as the assumptions you make. For example, if you decide to use capitalization, check if the business earnings are likely to change at essentially a constant rate going forward.

On the other hand, your earnings forecast will drive the accuracy of the discounted cash flow valuation. If the projection is not realistic, you can easily overestimate or underestimate the company’s true worth.

Business valuation: risk assessment, betas, and risk premia

Risk and return go hand in hand when it comes to valuing a business. The ability of a company to attract and retain the needed capital is essential in order to continue. The cost of capital is thus an important input in your business valuation.

Beta, a key element of the capital asset pricing model, measures the so-called systematic risk of a given company. In plain English, a company’s beta indicates how well the company’s stock price correlates with the market ebbs and flows.

The market beta equals 1. Any business whose beta is also 1 has the same level of risk as the overall equities market. In other words, the stock price moves up and down exactly with the changes in the broad stock market.

A company seen as a riskier investment will have a higher beta, as its stock price will fluctuate more than the market at large. A safer company has a lower beta. The investors tend to hold on to its stock longer and don’t drop it at the first sign of market volatility.

As you can see from the CAPM model, the company’s risk is the sum of the risk free rate of return plus the risk premium, the latter being the product of the company’s beta and the equity risk premium. The equity risk premium is the extra return the investors demand over and above a risk-free return on investments such as the long term US Treasury coupon bonds.

For public companies, whose stock trades on the open market, estimating beta is straightforward. If the company is privately held, historic stock prices are not readily available, so using betas of similar small public companies as a proxy is common.

When a beta is calculated for a public company, the correlation is established relative to a well known measure of the stock market. Typical choices are major indices such as Standard and Poor 500, or Morningstar US Market. Such broad indicators are all very good at predicting the overall market behavior, so the choice is up to you.

The key takeaway is no business operates in a vacuum. So a big part of your risk assessment is to see just how sensitive the company’s value is to the overall market.