The Discount Rate and Business Valuations

Written by: Zachary C. Reichenbach, CFA, CPA/ABV/CFF and Andrew Schmidt

As it relates to business valuations, the discount rate represents the required rate of return for an investor to invest in the business. Investors represent providers of capital in the form of equity and debt. The goal of this article is to discuss (1) the development of the discount rate, (2) provide examples of how discount rates are used in business valuation, and (3) current theory and application of discount rates taking into consideration the impact of the COVID-19 Pandemic.

There are typically two types of discount rates used in business valuation. The equity discount rate and the weighted average cost of capital (“WACC”). As defined above, the equity discount rate represents the required rate of return for an investor to invest in the business. The WACC takes this one step further and considers not only the return required by the equity provider of capital, but also the return required by capital provided in the form of debt (typically a bank).

Development of the Discount Rate

There are multiple methods used to calculate the cost of equity. We will focus on the build-up method in this article. The build-up method, as the name implies, represents the addition of multiple rates of return and risk premiums, expressed in percentages, which produce an equity discount rate. This process is illustrated as follows:

Risk-Free Rate (“RFR”)

The RFR is the rate of return available on investments free of default risk. The most appropriate proxy for the RFR is the yield on a 30-yr U.S. Treasury bond 10 years into its life cycle with 20 years remaining. This rate can be obtained from the Federal Reserve Statistical Release H.15. In the wake of the COVID-19 crisis, on May 6^th, 2020, the U.S. Treasury announced that it will begin issuing 20-yr treasury bonds to provide another investment vehicle to the public and help finance its longer-term obligations at today’s low interest rates.[1]

Equity Risk Premium (“ERP”)

The expected returns on equity are much less certain than U.S. Treasuries, and therefore, are riskier than the interest and maturity payments on U.S. Treasury obligations. Accordingly, in return for an increase in risk, investors demand higher returns for equity investments. This warrants an additional component of risk. Data is typically sourced from the Duff & Phelps Cost of Capital Navigator to develop this premium.

Size Premium (“SP”)

Small market capitalization stocks (“small-cap stocks”) are considered riskier investments than large market capitalization stocks; therefore, investors require additional return in exchange for the added risk of investing in small-cap stocks. The SP represents this additional return expected by an investor in the stock of a small-cap stock over that of an otherwise comparable investment in a larger company. Similar to the ERP, data is sourced from the Duff & Phelps Cost of Capital Navigator to develop this premium.

Industry Risk Premia (“IRP”)

The expected return demanded by investors is also impacted by the industry in which the entity operates. The Duff & Phelps Cost of Capital Navigator also provides the IRP for numerous industries which can be added as a component in the build-up method.

Specific Company Risk Premium (“SCRP”)

An SCRP is often appropriate to reflect unsystematic risk factors, or those risks which are specific to the company relative to the market as a whole. This is one of the areas where the judgment of the valuation analyst comes into play. Examples of unsystematic risk could include:

Financial history and current financial condition of the entity
Depth of management
Key-person risk
Concentration of customer base
Competition
Other

The sum of the above components produces the equity discount rate.

The development of the WACC considers the above equity discount rate, the cost of debt and the capital structure.

The cost of debt is based on the Company’s outstanding debt obligations and consideration of market conditions. Since the interest paid on most debt is still tax deductible after the passing of the Tax Cuts and Jobs Act (TCJA) of 2017, the interest rate applicable to this debt is typically tax-effected to produce an after-tax cost of debt.

Application of the Discount Rate in a Business Valuation

There are numerous ways the discount rate is used in a business valuation. We will discuss two ways, one in the application of the capitalization of earnings method, and the other in the discounted cash flow method, both of which represent income approaches.

Capitalization of Earnings Method Application

Under this methodology, the benefit stream of the company is divided by a capitalization rate to produce an initial value of the company before adjustments for either a discount for lack of control (minority interest discount) or discount for lack of marketability, if applicable. The equity discount rate or WACC is used to develop the capitalization rate. The capitalization rate represents the discount rate or WACC less the estimated long-term growth of the company. The benefit stream used with the equity capitalization rate would represent the benefit stream available to equity holders. The benefit stream used with the WACC capitalization rate would represent the benefit stream available to all providers of capital, both equity and debt.

Discounted Cash Flow Method (“DCF Method”)

The International Glossary of Business Valuation Terms defines the DCF Method as: “a method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate.” In this method, either the equity discount rate or WACC would be used to calculate the present value of the future benefit streams. Similar to the capitalization of earnings method discussed above, the benefit stream used with the equity discount rate would represent the benefit stream available to equity holders. The benefit stream used with the WACC would represent the benefit stream available to all providers of capital, both equity and debt.

It is important to note that a company’s current short-term and long-term debt must be deducted from the values produced using a WACC to arrive at the equity value of a company.

Discount Rates and COVID-19

The spread of the COVID-19 pandemic in early 2020 has had a significant effect on business valuations, and specifically on discount rates. Discount rates by nature are tied closely to local, national, and global economic performance, and will therefore change with the market. As volatility and risk in the face of COVID-19 increase, the discount rates being used in these types of models must also increase to account for these changes.

As a leader in the disciplines of valuation and risk, Duff & Phelps is providing guidance for clients and valuators alike during this challenging time. As stated previously, Duff & Phelps provides some of the most common sources of information for cost of equity data. A notice published on March 27, 2020 by Duff & Phelps cited supply chain disruptions, job losses, business closures, and collapsing equity markets as some effects of the spread of coronavirus. This instability in current markets has led Duff & Phelps to increase their United States ERP from 5.0% to 6.0%. As described above, ERP is a critical component when calculating discount rates, and this suggested increase (for developing discount rates as of March 25, 2020 and forward) reflects the severity of the current crisis. Keep in mind that the discount rate has an inverse relationship with value. As the discount rate increases, all things remaining constant, the value decreases.

When calculating cost of equity, as discussed above, multiple building blocks are considered (RFR, ERP, SRP, IRP, and SCRP). With the spread of COVID-19, most of these building blocks have fluctuated. Risk Free Rates are currently lower than before, as a result of the Federal Reserve slashing interest rates in recent weeks. On the other side of the scale, the Equity Risk Premium has increased, as a result of economic instability. Additionally, as companies are facing an economic downturn and the potential of going out of business as a result of the COVID-19, the SCRP will likley increase. The changes in these factors have resulted in an overall increase in discount rates across the board, as the valuation profession races to keep up with the ramifications of COVID-19.

Professor Aswath Damodaran is a teacher of business valuation and corporate finance at NYU’s Stern School of Business. He has published numerous articles and books on the topics. Damodaran has his own website and a blog which he uses as a platform to keep valuators updated on the perceived effects of COVID-19 on the financial marketplace. In addition to suggesting a COVID-Adjusted ERP of 6.02%, he explains that simply adjusting risk percentages for every valuation is not enough to account for the effects of COVID-19. He notes that “It is almost impossible to adjust for this concern (COVID-19) in discount rates and it is therefore imperative that you make judgements about the likelihood that your company will not make it, and this probability will be higher for smaller companies, young companies, and more indebted companies.” [2] In this time of uncertainty, Damodaran is suggesting that valuators cannot simply rely on the higher discount rates to account for COVID-19. Rather, experts must apply critical judgement more than ever before, to ensure that a fair value is calculated.

Discount rates have increased across the board in business valuations in response to the coronavirus pandemic. The combination of a higher ERP and a higher SCRP outweigh the lower RFR to create an inflated discount rate. Respected sources such as Duff & Phelps and Professor Aswath Damodaran are keeping risk assessment as up to date as possible as everyone navigates the uncertainty of the current situation. For the foreseeable future, the high risk associated with COVID-19 will continue to be a critical factor and must be considered when calculating a discount rate for valuations with an “as of” date subsequent to late February 2020. Experts must critically examine not only the appropriate increase in discount rate, but also the outlook for the company being valued as it relates to the pandemic.

[1] https://www.thestreet.com/investing/futures/20-year-treasury-bonds

[2]Aswath Damodaran, Musings on Markets_A Viral Market Meltdown V_Back to Basics! Published 03.31.2020

The Discount Rate and Business Valuations | Vallit Advisors (2024)