IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog has been provided by Kelly Deis of Soundpoint Consulting (www.soundpointconsulting.com).
Employment of a Discount Rate in Valuing a Privately Held Company
Anytime you are valuing a business, it is important to understand the concept behind the discount rate and how it is applied.
The value of a business is essentially the present value of the stream of future cash flows that the business will most likely generate.
Said another way, the value of a business is equivalent to the lump sum of money that, if the owner were to invest this cash at an appropriate rate of return, would generate the future cash flows that the business is expected to provide.
The “discount rate” is nothing more than the rate of return of an investment with comparable risk and expected returns. Here is the math of how the discount rate is applied:
Let’s assume a $1,000 investment with an annual rate of return 10%. Then, the value of the investment next year is $1,100:
$1,000 * (1 + 0.10) = $1,100
(today’s value * rate of return = tomorrow’s value)
Now, let’s flip it. If you know that you will receive $1,100 next year and the appropriate discount rate is 10%, then the value of $1,100 tomorrow is $1,000 today:
$1,100/(1+0.10) = $1,000
(tomorrow’s value/discount rate = today’s value)
The math is pretty straight-forward. Agreeing on an appropriate discount rate for a business is a little trickier as there is not an open market of comparable investment vehicles for privately owned companies.
A common way to derive the discount rate is called the “Build-Up Method”. This method adds different risk estimates to “build up” a discount rate. the components in the Build-Up Method include:
1. Risk Free Rate: The risk-free rate measures the rate of return an investor can earn without taking any additional risk. The 20-year US Treasury Bond or similar proxy is often used as the risk-free rate.
2. Equity Risk Premium: The equity risk premium represents the risk an investor accepts for investing in large public companies. This risk is measured by taking the average annual returns for large capitalization stocks minus average income returns for long term government bonds.
3. Size Risk Premium:The size risk premium is an additional risk factor for the size of the business. Empirical evidence shows that the smaller the business, the greater the risk. This risk factor is the average annual returns for small capitalization stocks minus average annual returns for large capitalization stocks.
4. Industry Specific Risk Premium: The industry specific risk premium is based upon the industry in which the Company operates. Some industries are inherently more risky than others, whether it be to cyclicality, potential litigation or some other factor.
The risk premium associated with equity, size and industry can be obtained from data published by Morningstar and/or Duff and Phelps.
5. Specific Company Risk Premium: The company specific risk premium is based upon company specific factors, such as financial performance, depth of management, dependence on key personnel, customer concentration, diversification of product line, competitive encroachment, as well as other factors. The specific company risk factor is determined by the evaluator based on his/her assessment of the business.
The discount rate is the sum of the five risk factors described above. If you have questions about building an appropriate discount rate for your business or business valuation, please give me a call.
If you have questions relating to business valuation or the content of this article, Kelly Deis, CVA, CEPA and President of Soundpoint Consulting, a business valuation and consulting firm specializing in business valuations, exit planning, strategy and operations business consulting, and financial services for marital dissolutions, would welcome inquiries. Kelly Deis can be reached at 206.842.4922, or email@example.com
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.