One of the more difficult tasks individuals face in reviewing and/or deciphering a professionally prepared business valuation is understanding some of the finance jargon within a valuation report. Two terms found in a valuation report that cause much confusion are discount rate and capitalization rate. The goal of this article is to help clear up the confusion and provide an introductory explanation and discussion of discount rates and capitalization rates. As a certified valuation analyst, I hear questions all the time about the terms used in valuation reports.
Is this the same cap rate I’ve seen used in commercial real estate analysis? (short answer, no)
How are these two rates used in obtaining an accurate value of one’s business interest? (explained later)
When do we use the capitalization rate versus using the discount rate? (explained later)
Let’s start with a typical book definition of these two terms. A discount rate represents the expected rate of return the investor would demand on the purchase price of ownership in an asset. The discount rate is used to derive present value factors and determine the value of a future or projected benefit stream. In the finance world the discount rate is also referred to as the required rate of return, opportunity cost, or the cost of capital. For our purposes, we will talk in terms of required rate of return. This required rate of return is also understood to be the rate that is necessary to attract capital to an investment and is highly affected by risk.
A capitalization rate is used as either a divisor or a multiplier and is applied, divided, or multiplied to net earnings or cash flow to determine value. Although capitalization rates and discount rates are technically not the same they are closely related. The theory behind discount and capitalization rates is quite logical. They find their basis in the concept of risk and reward.
Let me explain: based on the price to be paid for an investment the rate of return being offered when buying an investment must be high enough to justify taking the risk of purchasing the investment. Additionally, the return must be at least equal to the rate of return available from similar alternative investments. In the non-business world can understand, it means that if I’m going to bet on the long shot I want the pay off to provide better odds than the favorite.
Many times business periodicals such as, The Wall Street Journal seemingly use these terms interchangeably. At the end of the day many business owners ask the question, what is a discount rate and how is it any different from a capitalization rate?
The discount rate is driven by risk and we all know risk equals uncertainty. A discount rate is equal to an investors required rate of return. Therefore, the discount rate is equal to the risk-free rate (i.e. safe rate) plus the premium rate associated with the risk an investor takes that is above and beyond that which would be incurred with a safe investment. Now, we have the discount rate and how do we get the elusive capitalization rate? We just take the discount rate and subtract the growth rate. Hence, capitalization rate is usually lower than the discount rate assuming there exists growth. Easy, right?! Feel free to message me on LinkedIn.
Darrin Maddox MBA CPA CVA