The Expert Said What? Demystifying Valuation Jargon: Part 2, the Income Approach – Determining a Discount Rate

March 01, 2014

As discussed in the last edition of “The Expert Said What?”, it is not enough for a valuation expert to perform complex and accurate financial analyses; he must also be able to clearly and effectively communicate the results to a layperson. Our repeat readers will know the difference between a company “grossing” $10 million a year, and a business with $10 million in EBITDA. But, we’ve only begun to scratch the surface of the valuation lexicon. In this edition, we explore the determination of a discount rate utilized in the Income Approach to valuation. The Income Approach is perhaps the most widely used approach to private company valuation, yet the most challenging to explain. For purposes of our discussion on the Income Approach, we will again be referring to Susie’s Sunshine Lemonade (“Susie’s”), a successful chain of high-tech, kid-operated, and parent-sanctioned lemonade stands. Our work in this article will result in a discount rate which will later be utilized to calculate the present value of projected cash flows for Susie’s. A summary of Susie’s earnings metrics is shown below.

To review, Free Cash Flow to the Firm (“FCFF”) is defined as cash flow available to pay stockholders and debt holders (the collective investors in a business) after consideration of any cash reinvestment required to support the company’s continued operations and future growth. The pie chart on the next page shows the breakdown of Susie’s FCFF into free cash flow to equity holders and free cash flow to debt holders. From a practical standpoint, the free cash flow available to equity holders is equal to total FCFF minus debt payments (principal and interest).

The Time Value of Money

When asked what the time value of money is, most people say, “a dollar today is worth more than a dollar tomorrow.” This is true, but why? The answer is that you can invest a dollar today, and when you get it back tomorrow, it will have yielded a return (albeit small) such that you received more than a dollar. To illustrate this concept, let’s assume the U.S. Treasury is selling 1-year bonds with a 3% yield. There is little risk of the U.S. government defaulting on its debt, so an investor with $10,000 is guaranteed to have $10,300 next year. Reversing the math produces the following: since the investment will give you $10,300 in a year, the time value of money suggests that the present value is $10,000.

Another explanation for why a dollar is worth more today than tomorrow is inflation. Assume you are buying a new fridge for $1,500. The salesman offers you 12 months “same-as-cash” financing, meaning at your option you can pay the entire price of the fridge today, or in 12 months without interest. If you are a rational investor, you would most likely choose to pay the full price next year. In the meantime, your $1,500 can immediately be used to purchase gasoline, groceries, a fancy new TV, or an investment of your choosing. However, if you wait until next year, normal inflation will cause the $1,500 to buy you incrementally less of everything.

Present Value

The basic conceptual underpinning to the Income Approach is the theory that when an informed investor is making a decision whether or not to invest in a particular company, he/she is considering the present value of the returns he/she will receive over time as an owner of that company. This is accomplished by 1) projecting a stream of future economic benefits (we’ll assume Free Cash Flow to Firm in this article) and 2) discounting those benefits to a “present value.” The rate at which those future economic benefits are discounted is aptly referred to as a discount rate. In the U.S. Treasury example, the discount rate is 3%, the market rate the government is paying in exchange for your investment today. With the cash flows of a private company, deriving a discount rate is more complicated. This is intuitive because the private company’s stock is not being offered publicly with a stated return.

A discount rate is often referred to as a “required rate of return” because it is equal to the rate required by potential investors based on the relative risk of the investment. The chart below illustrates the related risk and required return for different example classes of investments. The lower the investment is on the chart, the greater the risk, and therefore the greater the required return.

The discount rate accounts for two broad types of risk. The first type quantifies the time value of money (i.e., the risk that the value of a dollar is greater today than tomorrow). The second type quantifies the risk that the projected returns may or may not actually be realized, and that the investment itself may not be recoverable.

In valuing an entire company like Susie’s, we will utilize projected total FCFF as our economic benefit and weighted-average cost of capital (“WACC”) as the discount rate to calculate the present value of the projected FCFF. The first step in determining the WACC applicable to a subject company is calculating the cost of equity.

Cost of Equity

The cost of equity, or required return on equity, is the rate of return investors expect and demand when investing in the equity of a company. It encompasses both the time value of money as well as the incremental risk premia associated with the characteristics of the investment. While there are differing opinions on the preferred method for estimating the cost of equity, there is little argument over what the theoretical components of risk are. These components are:

  • Risk-free rate of return
  • Equity risk premium
  • Industry risk premium
  • Size risk premium
  • Company-specific risk premium

These layers of risk are discussed in greater detail below and summarized in the accompanying graph of layered components of risk totaling the cost of equity for Susie’s Sunshine Lemonade.

As previously mentioned, this article series will walk the reader through a hypothetical valuation of Susie’s Sunshine Lemonade. In order to value the company, we first need to quantify the appropriate discount rate at which we will discount the projected future cash flows to a present value. Because we are valuing the entire operations of the company, we must quantify the inherent risk and required return demanded by both the debt and equity holders of the company. First, we will address the components of the required return for equity investors.

Risk-Free Rate of Return

The risk-free rate of return can be thought of as the rate of return demanded by an investor if there were absolutely no risk of loss of the investment. Because there is no risk of financial loss, this return compensates the investor for the time value of money (previously discussed). While there is no such thing as a truly riskfree investment, valuation experts often utilize the yield on long-term U.S. Treasury securities as a proxy. As of the writing of this article, the yield on such securities is approximately 3.5%.

Equity Risk Premium

While investing in U.S. government bonds is considered to be relatively risk-free, investing in equity (stocks) is incrementally riskier. Evidence has shown that current diversified equity investors demand long-term returns over the risk-free rate of approximately 6%. Layering this equity risk premium on top of the risk-free rate suggests that investors in a broad range of U.S. stocks require a return of approximately 9.5%.

Industry Risk Premium

Financial theory suggests (and empirical studies support) that investors perceive certain industries to be riskier than others. For example, agricultural companies have less risk than average (probably because of the steady demand for food), while construction companies have greater risk than average (probably because of the boom/bust cyclicality of the real estate industry). Hence, investors in construction companies require additional returns to compensate for the additional borne risk, while agricultural investors will accept lower returns commensurate with their lower borne risk.

For purposes of our valuation of Susie’s, let’s assume that the restaurant industry is riskier than average, and investors require 2% greater returns for that risk. Layering this industry risk premium on top of the equity risk premium suggests the required return for investing in a portfolio of U.S. restaurant stocks to be 11.5%.

Size Risk Premium

Similar to the industry risk premium, evidence has shown that investments in small companies carry more risk, and therefore a greater return than investments in large companies, everything else held constant. The size risk premium is added to account for this incremental risk and return above and beyond what is captured in the equity risk premium. For purposes of Susie’s, let’s assume studies show that companies of similar size require incremental returns of 8%.

Adding the size risk premium layer, we have quantified the required return of investing in a portfolio of small restaurant stocks to be 19.5%.

Company-Specific Risk Premium

The company-specific risk premium takes into account a number of risk factors unique to the subject company. Examples of common company-specific risks are:

  • Lack of product diversification
  • Concentrated customer base
  • Lack of management depth
  • Lack of geographical diversification
  • Short operating history

None of the above company-specific risk factors are previously captured in the equity risk premium, industry risk premium, or size risk premium. In the case of Susie’s, all of these happen to apply.The company only sells lemonade (mostly to the under-14 age group), is primarily run by Susie and her brother, has no locations outside of Southern California, and has only existed for three years. Based thereon, let’s assume a company-specific risk premium of 4% applies. We add this 4% to the previously calculated required return (19.5%) of investing in a portfolio of small restaurant stocks, and we arrive at 23.5%, the required return an equity investor would require to invest in a company like Susie’s.

Note that as we have added layer upon layer of risk premia, we have cast a tighter and tighter net around the rate of return applicable to Susie’s. Identifying the unique risk profile of a company is analogous to an actuary determining life insurance risk for an individual. Not every person carries the same risk so the actuary will need to gather important information such as gender, age, race, affluence, lifestyle, and preexisting health problems. Each piece of information allows the actuary to zero in on the specific risk for the individual seeking life insurance.

Similar to the life insurance example above, perhaps the accompanying graph is more appropriate to show how as layers of risk are considered, the result is a customized rate pointing directly at the risk and required return characteristics of a subject company’s equity.

Cost of Debt

The second input in the weighted-average cost of capital calculation is the required rate of return on debt. This is the return a prudent investor would require to provide debt financing to a subject company. While the underlying components of a company’s cost of debt are similar to the components of the cost of equity, it is usually a much simpler task to estimate the applicable cost of debt. This is because banks and other financial institutions routinely lend money to both public and private companies and information on lending rates is usually readily available during the course of a valuation. In the case of Susie’s, a recent 10-year bank term loan was negotiated at a rate of 5%. Therefore, let’s assume 5% is Susie’s cost of debt.

Because interest payments on debt are tax deductible, while equity dividends are not, there can be a tax advantage for companies to borrow in the form of debt. To account for the tax-deductibility of interest payments, the 5% is reduced by the interest “tax shield”. In this case, Susie’s tax rate is 34%, so the effective cost of debt is actually 5% * (1 – 34%), or 3.3%.

Capital Structure

The last major input required to calculate the appropriate discount rate when valuing an enterprise is the assumed capital structure. The term capital structure means the percentage of the operating value that is owned by the equity holders versus the debt holders. A home with a mortgage can be a good example of capital structure. Assume the home is worth $500,000 and there is a $350,000 mortgage. Therefore, the owners’ equity is $150,000. Their home’s capital structure is 30% equity/70% debt.

There are different methods that can be utilized to determine the appropriate capital structure for a business, but let’s assume the appropriate capital structure for Susie’s is 25% debt and 75% equity.

Weighted Average Cost of Capital

Typically, a company’s assets are financed by either debt or equity, each bearing its own risk and return characteristics. WACC is the average of the costs of these sources of financing. Simply put, the WACC of a company is a rate of return that represents the combined return required by all investors, debt, and equity. When utilizing a WACC, all available cash flows generated by the subject company are projected. These cash flows can be referred to as “debt-free” because they are measured before payments of interest and principal to debt investors.

For purposes of calculating a weighted-average cost of capital for Susie’s, we have first determined the cost of (or required return on) equity at 23.5%, and then the cost of (required return on) debt at 3.3%. Finally, we must determine the appropriate capital structure, or allocation, of equity and debt to weight each of these returns. There are different methods that can be utilized for these purposes, but let’s assume the appropriate capital structure for Susie’s is 75% equity and 25% debt. We apply these weightings to the cost of equity and cost of debt, respective, in the following equation:

WACC = Cost of Equity x Equity % + Cost of Debt x Debt %

WACC = 23.5% x 75% + 3.3% x 25%

WACC = 18.45%

Therefore, the total weighted-average cost of capital applicable to Susie’s FCFF is 18.45%, or just 18.5%, rounded. This WACC will be utilized as our discount rate when calculating the present value of projected cash flows.

Conclusion

In the first article in this series, we discussed levels of earnings and Susie’s historical earnings performance. This edition discussed the components of a discount rate utilized in the Income Approach to valuation. Since you’ve made it this far in your reading, we encourage you to tune in next time when all our hard work will begin to pay off. We will put the Income Approach to work, projecting cash flows, calculating present values, and maybe even arriving at a value for Susie’s. Until then, whether it be for knowledge or Sunshine Lemonade, stay thirsty, friends.

Also contributing authors:

Ryan J. McLean