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When a business is valued based on expected earnings or cash flow, a discount rate converts future dollars to present value. (At a 10% discount rate, a payment of $100 due in a year is worth $100 ÷ 110% or $91 today.) Where does the discount rate come from?
The most important thing to know about discount rates is that they are ESTIMATES of the future that cannot be precise, just like forecasts of earnings and cash flow. Discount rates like 23.62% are highly misleading. How can you possibly be that accurate about an unknown? (I round my discount rates to the nearest 1%, and that is a stretch.)
Estimating discount rates is one of the hardest parts of business valuation. My valuation students always tense up when I raise this issue. So do most appraisers! The estimating techniques are complicated. Valuation reports are full of unfamiliar, intimidating terms like “company specific risk premium” and “beta.”
Estimating discount rates requires common sense, informed judgment, and reasonability. Here is how I introduce discount rate estimation to new students (before we get into the technical stuff). It is also how I check the reasonability of my own estimates. I hope it helps you do so without wading into the technical deep end.
Remember that discount rates are estimates of the unknowable future. Leave the technical aspects to appraisers and use common sense, informed judgment, and reasonableness to check them.
Valuations play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call.
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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.
Western Reserve Valuation Services is an affiliate of Western Reserve Partners LLC, a FINRA-member investment banking firm offering financial advisory services relating to mergers and acquisitions, capital raising and financial restructuring. For more information on Western Reserve Partners, please www.wesrespartners.com or call (216) 589-0900.