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Overview |
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ValuSource valuation applications use data from the Stocks, Bonds, Bills, and Inflation® (SBBI®) Valuation Edition Yearbook to develop discount and capitalization rates for the income approaches to valuation. Estimating the cost of capital is one of the most important and difficult issues in performing a business valuation. ValuSource valuation applications use both the buildup and CAPM approaches to estimate the cost of capital.
Using SBBI® data as a foundation, the appraiser can estimate the systematic risk associated with a business enterprise to be combined with the unsystematic risk elements related to a specific company and use that combined risk to calculate the value of the company. Keep in mind that unsystematic risk is subject to valuator judgment. The general formula for calculating value is:
Economic Benefit Stream ÷ Risk = Value
For example, a perpetual $100 economic benefit stream associated with a 10% risk would be worth $1,000 today ($100/0.10). This concept works for both single and multiple period approaches (discounting future streams as well as capitalizing current streams).
It is important to understand that using Ibbotson data gives the appraiser an entity level, after tax, cash flow discount rate. Cash flow being available cash, including dividends and appreciation. A capitalization rate is developed from a discount rate, as shown below.
The essence of the cost of capital is that it is the percentage return that equates expected economic income with present value. The expected rate of return in this context is called a "discount rate". A discount rate reflects both the time value of money and risk and therefore represents the cost of capital. The terms "discount rate," "cost of capital," and "required rate of return" are often used interchangeably.
It is also important to understand a discount rate is not the same as a capitalization rate. A discount rate is applied to all expected future returns to convert the expected future benefit stream to a present value. A capitalization rate, however, is merely a divisor applied to one single element of return, to provide an estimate of present value. Discount rate and capitalization rate are related by the following formula:
Discount Rate – Sustainable Growth = Capitalization Rate
Keep in mind that sustainable growth is a very important element in determining the final value of a company. Many in the valuation community argue that sustainable growth cannot exceed the growth of the consumer domestic product plus inflation, which historically has been slightly less than 6 percent. Also realize that sustainable growth, for the adjustment noted above, is the sustainable growth in perpetuity. Therefore, it may be significantly lower than current growth for a particular valuation target.
Growth rate information for particular industries can be found in the Ibbotson Cost of Capital Quarterly data, which is available by the SIC code at their web site at www.ibbotson.com.