Under the income approach to business valuation, the discount rate is one of the key inputs in determining a company’s value.
In the book Valuing a Business, Shannon P. Pratt (one of the leading pioneers in valuation theory) defines a discount rate as follows: “In economic terms, a present value discount rate is an ’opportunity cost,’ that is, the expected rate of return (or yield) that an investor would have to give up by investing in the subject investment instead of investing in available alternative investments that are comparable in terms of risk and other investment characteristics.”
In simpler terms, if a company is considered more risky in comparison to another company, the investor would require to be compensated in the form of a higher rate of return for investing in the riskier company. The higher the discount rate translates into a lower value for the subject company.
The components of a discount rate include the risk-free rate and various risk premiums.
The risk-free rate is the rate that is foregone by not investing in securities that are considered to have no risk of default, which are generally considered to be U.S. Treasury obligations.
Risk premiums for investing in an equity security (the “equity risk premium”) and for the smaller size of the company being valued in comparison to the publicly-traded companies from which discount rate data is derived (the “size premium) are then added.
Finally, an adjustment is made for specific company risk, which is an adjustment that requires significant professional judgment to capture the risk associated with the factors listed below:
- Economic and industry risk – What is the current economic outlook? Is the industry cyclical or are there unique industry risks that need to be considered?
- Financial risk – Is the subject company highly leveraged? Is there sufficient net working capital for the business to operate effectively?
- Operational characteristics – How do the company’s margins compare to other companies in its industry? Are there significant customer, supplier or employee concentrations?
- Key employee risk – Does the subject company rely heavily on one or more people in order to conduct operations? Are suitable replacements available in the marketplace if a key employee were to leave the company?
- Size of the company – Is the company smaller than even the low end of the companies considered in determining the size premium?
- Projection risk – How consistent are management’s projections with the company’s historical levels of activity?
These are just some of the specific company risks to consider when building a discount rate to value a business using the income approach. Every company’s risk profile is different and a company’s discount rate will even likely change over time. Therefore, developing a sound, specific company risk adjustment plays a key role in supporting a company’s discount rate and arriving at a supportable conclusion of value.
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