This is an update of a favorite subject: discount rate development.
When I teach introductory BV, things go smoothly as we cover standards and premises of value, economic, industry, company, and financial analysis and forecasting, and the Market and Asset Approaches. When we get to the Income Approach, however, the level of anxiety always rises and students get very quiet when we get to discount rate buildups, CAPM and so forth. (When I took the courses, I was just as anxious and quiet. Come to think of it, I still am!)
To allay this, I broach the topic with a little riff that does not mention Ibbotson, Duff & Phelps, the Capital Asset Pricing Model, or any other powerful and complicated technical information. I call this “The Fastest Two Minutes in Business Valuation”, and it goes like this:
Investment risk and return move together. The higher the risk, the higher the return investors require. We are valuing the equity of small privately owned businesses. How can we get a handle on their appropriate rate of return?
On the high side, venture capital investors (in startups) require at least a 40% annual rate of return. The businesses we normally value are more established with less risk than startups, so their annual rate of return ought to be less than 40%.
On the low side, “mezzanine” (a combination of high-coupon subordinated debt and “equity kickers” like stock warrants) investors require at least a 20% annual rate of return. The equity in the businesses we normally value has greater than mezzanine risk because it is subordinated to all debt, so their annual rate of return ought to be more than 20%.
(These rates of return are AFTER corporate taxes and BEFORE personal taxes, just like net cash flow to equity, the preferred benefit stream in the Income Approach.)
To summarize, the rate of return is usually greater than 20% and less than 40%. Special circumstances may lead to rates outside this range, but they are rare. This is a workable, reasonable, and defensible range.
To use an analogy, call the 20% rate white and 40% black. How many shades of gray can we determine? I feel comfortable with three: light gray, gray, and dark gray. I don’t feel comfortable being more discriminating than that. Therefore, below-average risk bears about a 25% rate, average about 30%, and above-average about 35%. The risk level assessment is based on economic, industry, company and financial analyses.
That’s how I visualize and initially assess discount rates! The rest of what we will learn concerns how to back that up!