Step 6 to Reviewing a Valuation Report – Discount Rate Reasonableness

Is the valuation based on a going concern income-based approach such as a discounted cash flow approach (DCF) or capitalized cash flow approach (CCF)?  If so, what discount rates or capitalization rates are the value conclusions based upon?

Step 6 to reviewing a business valuation report involves assessing the reasonableness of the selected discount rates or capitalization rates (or "cap rates").

Although discount rates and cap rates are related terms, they are not interchangeable.  For clarification, each of these terms is discussed briefly below:

Discount Rate

A discount rate is the rate of return used to convert a monetary sum or series of future anticipated cash flows into a present value. [1]

A discount rate is used in a DCF approach to convert the discretionary cash flows forecasted over a projection period to a lump sum present value.  The discount rate is a function of the perceived risk associated with the business actually achieving the projected cash flows in comparison to the return on a benchmark ‘risk-free’ stream of cash flows. [2]

Capitalization Rate

A cap rate represents the rate of return used to convert a uniform (or constant) stream of future cash flows into a lump sum present value.  The inverse of the cap rate is referred to as the multiple or multiplier. [1]

A cap rate is used in a CCF approach to convert the estimated annual maintainable discretionary cash flows to a lump sum present value.  There is an inherent assumption that the annual maintainable cash flows will be generated to perpetuity.  The cap rate is derived when a growth factor is deducted from the discount rate.  The growth factor can be comprised of expected long term inflation and an incremental real rate of growth. [2]

Discount rates and cap rates are usually expressed as either a weighted average cost of capital ("WACC") or as a levered return on equity.  WACC is applied to discretionary cash flows before debt service costs to arrive at a company’s enterprise value.  The levered return on equity is applied to discretionary cash flows after debt service costs to arrive at an equity value directly.

The reasonableness of the discount rate and/or cap rate assumptions can significantly affect the integrity of the resulting value conclusions.  The business valuator must select and appropriately apply discount rates and cap rates that he/she believes accurately reflect the risk associated with the target company being able to achieve the future cash flows.  This risk assessment is an area where judgment is required and is often a common area in which valuators (and potential purchasers for a particular business interest) will differ.

The following principles should be followed when deriving and applying discount rates and cap rates:

Discretionary cash flows – discount/cap rates should be applied to cash flows after taxes, capital investment and incremental working capital needs
Internal consistency between the discount/cap rates and the cash flows – areas for consistency include pre-tax versus after-tax, inflation assumptions and real growth considerations
Risk and return tradeoff – all other things equal, the more aggressive or optimistic the cash flow projections the higher the discount rate should be
Operating and financial risk – discount/cap rates should consider both operating risk (risk that the projected unlevered cash flows will not materialize) and financial risk (incremental risk assumed by equity holders resulting from the use of debt financing)
Market rates of return – required rates of return are influenced by the prevailing general market rates of return and anticipated changes in market rates at the time

The above noted areas should be considered when reviewing a business valuation report to assess the reasonableness of the discount/cap rates adopted by the business valuator.

Reasonable and supportable discount rate or cap rate assumptions are critical to a reliable value conclusion.  Depending upon the scope of review, inquiries and experience level, this is an area where business valuators can differ significantly.  As a result, assessing the reasonableness of the discount/cap rates should be a major focus in reviewing a business valuation report.

If you have any questions regarding assessing the reasonableness of discount or cap rate assumptions or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.

__________________

1.  Source: Canada Valuation Service, Ian R. Campbell, Howard E. Johnson, H Christopher Nobes, 2010.

2.  Source: The Valuation of Business Interest, Ian R. Campbell, Howard E. Johnson, 2001.