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.