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For What It’s Worth: On Discount Rates – May 2016

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.

  1. Ask yourself how risky the subject business is: Low, Medium, or High. Risk is how uncertain future earnings or cash flows are. This reflects the economy, the industry, and business and financial positions of the company, all of which are part of a valuation report.  In my opinion, most business owners and advisors can answer this without strain.
  2. Establish a reasonable range for the discount rate. The riskiest businesses are startups and early-stage firms, for which venture capital investors expect annual rates of return of at least 40% on their equity.  That is the upper bound.  The least risky businesses ought to have annual rates of return of no less than 20% on equity the rate of return on mezzanine financing (senior to equity but junior to other debt).  You can debate the numbers, but they set a reasonable range of 20% to 40% (net of corporate but gross of investor taxes) for return on equity.  Weighted average returns on total capital (“WACC”), which include debt and equity, are lower.
  3. Put it all together! A Low Risk business should have an equity cash flow discount rate of around 20%, Medium should be about 30%.  High should be about 40%.  You just estimated a discount rate!
  4. If your estimate is close (give or take 5%) to what the appraiser found, then everything is fine. If not, go back to the first step and discuss it with the appraiser.  That discussion will be on point and will strengthen the quality of the valuation, as well as increase your confidence in it.

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.

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