Intermediate Valuation: Methods to Determine a Discount Rate

When it comes to Mergers & Acquisitions, business valuation plays a vital role in determining a business’s ‘Best’ estimated value.

Most business owners and entrepreneurs are unaware of the valuation process and how they should go about it. Although surprising, this scenario is not uncommon as the business valuation process is complex, with multiple steps and different approaches. It is equally important to understand the purpose of business valuation, understand the factors that impact the company and the industry, consider the competitive and economic factors, and select the right valuation approach and method.

Business valuation is typically conducted under these three scenarios:

  • When looking for investors and capital,
  • When the business owner is offering a business partnership or equity with key employees, and
  • When selling a company.

Valuation helps the business owners understand the business’s intrinsic value, which is different from the company’s price.

Price is the precise value of a company, realized at the time of sale, influenced by synergistic buyers, and competition in the marketplace. On the contrary, the company’s value refers to what a potential buyer is willing to give the owner.

Understanding this, business owners should consider these three critical aspects while conducting the valuation:

  1. Measure the current value of all value generating elements within the company
  2. Evaluate the company’s competitive position within the industry sector, and
  3. Evaluation of future financial expectations.

Before measuring the value of a business, it is essential to list the reasons and circumstances for the evaluation, also known as ‘Business valuation standards,’ which refers to the hypothetical conditions for business valuation and ‘Premise of value,’ which relates to assumptions that the business will continue to flourish in the current state or that the value of the company is the actual profits from the sale of all business assets minus the debt.

Business Valuation Approach

There are three approaches to Business Valuation.

  1. The Income Approach to conclude value by calculating the net present value of the profits generated by the business.
  2. The Asset-based Approach determines the value by adding all the business assets.
  3. The Market Approach, to decide the value by comparing the subject company with other companies of the same industry.

Equity professionals and venture capitalists use models that combine the income and market approaches for complete business valuation. Since each technique has its pros and cons, it is essential to consider all the underlying aspects before applying them to a particular company.

An in-depth look at ‘The Income Approach’ and its most widely-used models.

The income approach is based on the principle of expectation, which means that a business’s value is determined based on expected gains and the risk associated with the investment.

The valuation methods decide the business’s fair market value by dividing the company’s ‘gains’ by the ‘capitalization’ or ‘discount rate.’ To simplify further, the income approach valuation methods help decide the value of a business on its ability to create anticipated economic value for the business owner.

The economic gains such as the company seller’s discretionary cash flow (pre-tax earnings before non-cash expenses) or the net cash flow (what the owners can remove from the business without affecting the business operations) are capitalized, reduced, or multiplied to conduct the valuation.

The most well-known methods under the income approach are:

Capital Asset Pricing Model (CAPM)

The objective of any investor is to weigh the risk associated with the return of a potential investment. To quantify this, investors may deploy the use of the capital asset pricing model, or “CAPM.”

CAPM is an extended version of the portfolio theory of Markowitz that explains the relationship between expected return and risk of investing in a security. CAPM explains how assets should ideally be priced in the capital market. The objective is to reduce the risk for any given return.

The Capital Asset Pricing Model demonstrates the association between the expected returns and the risk of investing in security.

Formula of calculation

Expected Return = Risk-free Rate + (Beta x Market Risk Premium)

This method revolves around the idea of systematic risk, also known as non-diversifiable or market risk, which the investors need compensation for, known as the risk premium. CAPM is based on the concept of risk (through volatility) and rewards (rate of return). Investors naturally prefer to gain the highest possible returns along with the lowest volatility of returns.

An expected Return is an assumption about how the investment will yield in the long term.

A risk-free rate is typically equal to the return on a ten-year US Government Bond. The risk-free rate should match the country where the investment is made, and the bond’s maturity should check the investment timeline.

Beta measures a stock’s unpredictability, which is depicted by assessing the price fluctuations considering the overall market. Simply put, it is the stock’s sensitivity to market risk.

Market Risk Premium is the extra return that the investor receives or expects to receive for holding a risky market portfolio rather than risk-free assets. The more volatile the market, the higher the risk premium.

Assumptions of the Model:

  • The investors can make their decisions based on the return assessments (expected returns & standard deviation measures)
  • The sale transactions and purchases are assumed as divisible units.
  • Investors can sell any number of shares.
  • Fosters the condition of perfect competition as no single investor can influence the price without transaction costs.
  • Personal income tax is presumed to be zero.
  • The investors can borrow or lend the desired amount at a riskless rate of interest.

Pros

Usage

CAPM is a simple calculation that is stress-tested to choose possible outcomes to build confidence about the required rates of return.

Diversification of Portfolio

Unsystematic risk is eliminated as the model assumes that all investors hold a diversified portfolio just like the market portfolio.

Business and Financial Risk Variability

While investigating opportunities, if the business mix and financing differ from the current business, then CAPM is the most suitable model to compute all the other return calculations, which is not a viable option with WACC (weighted average cost of capital).

Cons

Omits unsystematic risk

CAPM does not consider the individual subject company when quantifying the discount rate. It is essential to weigh the specific risk factors inherent to a particular company or investment and not just the market at large.

Convenience to borrow at Risk-free Rate.

One of the assumptions of CAPM is that investors can borrow and lend at risk-free rates, which is unrealistic in the real world. Individual investors cannot borrow or lend at the same rate as the government. The actual returns are much lower than what the model calculates.

Proxy Beta

When businesses use CAPM to assess investments, they need to find a beta that is indicative of the project or investment. So, a proxy beta is often necessary. However, since it is difficult to accurately determine a proxy beta for assessment, this can compromise the reliability of the outcome.

Weighted Average Cost of Capital (WACC)

Commonly referred to as a firm’s cost of capital, WACC is the total cost of money from all sources. WACC is the minimum return a business must earn on its asset base (existing) for its owners, lenders, and other capital providers to ensure future investment continuity for a business.

A business raises capital from several sources: common stock, preferred stock, straight debt, convertible and exchangeable debt, warrants, options, stock options for executives, subsidies, etc. WACC establishes the cost of each part of the company’s capital structure, considering the equity, debt, and stock.

To calculate WACC, the relative weights of each element of the capital structure are taken into account. The more complex a company’s capital structure, the more difficult it is to calculate WACC. Companies also use WACC as a means to see the value of the investment projects available to them.

Related: Working Capital. 

Formula of Calculation

WACC = (E/V x Re) + ((D/V X Rd) X (1-T))

E is the market value of the company’s equity

D is the market value of the firm’s debt

V is the total value of capital, i.e., equity + debt

E/V is the percentage of equity capital

D/V is the percentage of debt capital

Re the required rate of return

Rd total cost of debt

T is the tax rate

The Cost of Equity is calculated using CAPM to equate risk vs. reward.

Cost of Debt & Preferred Stock

The cost of debt is the total return on maturity on a company’s debt, and likewise, the price of the preferred stock is the return on the company’s preferred stock. To calculate, multiply the cost of debt and the return (yield) on the preferred stock with the percentage of the debt and preferred stock, respectively.

However, since the interest payments are tax-deductible, the cost of debt should be multiplied by (1- the tax rate), also referred to as the value of the tax shield. And since dividends are paid after-tax profits, this is not done for preferred stock.

To derive the after-tax cost of debt for the WACC formula, all outstanding debt’s weighted average current yield is multiplied with one minus the tax rate.

Purpose of WACC

WACC is the discount rate for the calculation of NVP (Present Net Value) of a company. WACC represents the firm’s opportunity cost as it is used to access investment opportunities.

Businesses use WACC as a hurdle rate for evaluation in Mergers & Acquisitions and financial demonstration of internal investments. Suppose the investment opportunity offers a lower Rate of return than its WACC. In that case, the business should ideally buy back its shares or pay a dividend rather than further investment in the project.

Assumptions of WACC for New Projects

  1. Unchanged Capital Structure: The capital structure is the same as the existing structure. To simplify, suppose a company has a debt ratio of 70:30 to equity in the balance sheet, the addition of a new project will maintain the same ratio.
  1. Unchanged Risk of New Projects: The associated risk of a new project will remain unchanged. For example, a business expanding its existing machinery will have the same risk profile as the industry peers.

Pros

Easy and Simple

WACC calculation is not complicated, the weightage is applied to each source of finance with its cost, and the result is an aggregate of it all.

Single Hurdle Rate (Opportunity cost of capital)

A lot of evaluation time is saved because of a single hurdle rate. If projects have similar risk profiles with no change in capital structure, WACC can be applied effectively.

Effective Decision Making

Since the single rate is used for all new projects, little time is wasted in decision-making.

Cons

Maintaining the Capital Structure

WACC follows the assumption that ‘no change in Capital Structure’ is impractical to apply, as it proposes the same capital structure for new projects. In such a scenario, there are two possibilities.

  1. To fund the new project with retained earnings or support the new project with the same capital structure. The only limitation here is the availability of free cash to do so.
  2. To raise funds in the same capital mix, while not impossible, it is difficult to secure funds on own terms and conditions quickly.

To resolve the above issues, businesses should consider the target capital structure rather than the existing one. So WACC calculation should be adjusted accordingly.

Accepting and Rejecting Projects

Assuming the same risk profile of new projects has drawbacks. To simplify, consider two scenarios.

  1. Business expansion within Industry. Though the assumption is reasonably accurate, it still does not consider the risks associated with installing new machinery in the present. Changes like new technology, quality, and cost are not considered.
  2. Expansion in different industries, the same risk assumption is entirely impractical in this scenario, as no two sectors, such as FMCG and textile, have a similar risk profile. The cost of equity is also different, so applying the same WACC poses a higher risk of rejecting a good project.

Effect of Current Market Cost of Capital

WACC evaluation for any new project requires the present-day cost of capital, and knowing these costs is challenging. Economic changes also impact the interest on the cost of debt; similarly, the expected dividend keeps changing.

Other Sources of Capital Overlooked

Only debt, equity, and preference shares are taken into consideration for WACC calculation. Factors such as convertible preference shares, debt, stock market bonds, warrants, or extendable warrants are overlooked as they will make the calculation complex. If these are also introduced, they will undoubtedly impact WACC.

Build-Up Method

In this method, valuation starts with a risk-free rate. The analyst determines what percentage is to be added to the risk-free rate, so consistency is maintained between the earnings and the capitalization rates in valuation. This amount to be added depends on the risk associated with business earnings. The value of a business is calculated by dividing the adjusted earnings by the capitalization rate.

This method of valuation is mainly used for small to medium-sized companies.

Formula of Calculation

Re = Rf + ERP + IRP + Rs + Rc

Rf = Risk-free rate of return

ERP = Equity risk premium

IRP = Industry Risk premium

Rs = Size premium

Rc = Specific company risk

U.S. Treasury note rate is generally used for the risk-free rate, whereas the equity risk premium can be sourced from professional publications. There is more risk associated with investing in smaller firms, so size risk premium takes this into account. The items that define company-specific risk is – Management depth & expertise, access to capital, leverage, product diversification, availability of labor, employee stability, demographics, economic factors, distribution system, location, political risk, global risk, size.

The analyst assigns a value to such aspects while developing the risk factor. All these considerations determine the discount rate. Though the calculation is straightforward, the complexity lies in an accurate assessment of all the elements of the capitalization rate.

Pros

Primary Valuation Method

It is the most reliable and robust method of business valuation

Cons

The specific company risk is difficult to quantify and is based

To sum up!

There is no simple way to answer which approach is the best business valuation approach. Each of the approaches has its unique advantages and disadvantages since many factors like- specific industry norms, current market, fluctuating interest rates all impact the findings.

Aside from this, one of the biggest mistakes business owners make is not seeking professional help. A strategic approach and sound guidance from a valuation firm will help you understand the value of your business.

Get in touch with us if you are ready to know the worth of your business!

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Author Summary:
Dan Doran

Dan Doran

Is the Founder of Value Scout, Quantive and the 2019 Exit Planner of the Year. He is a recognized expert and speaks frequently about M&A, valuations, and developing more deliberate value creation strategies.

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