In an income approach valuation, two numbers determine the answer: the expected benefit stream and the rate used to convert it into present value. Owners and attorneys spend most of their attention on the first. Experienced reviewers spend most of theirs on the second, because the rate is where judgment concentrates and where reports most often break.
A two-point difference in a discount rate is not a rounding issue. On a business with $1 million of capitalized earnings, moving the capitalization rate from 18% to 20% removes roughly $555,000 of value.
What the rate represents
The discount rate is the return an investor would require to accept the risk of the subject’s expected cash flows. Higher risk, higher required return, lower present value.
The capitalization rate is derived from it: the discount rate less the expected long-term sustainable growth rate. Confusing the two is a basic but surprisingly common error. A discount rate is applied to a stream of projected cash flows; a capitalization rate is applied to a single representative period’s benefit.
The rate must also match the benefit stream:
- An after-tax rate goes with after-tax cash flow
- An equity rate goes with cash flow to equity
- A weighted average cost of capital goes with cash flow to invested capital
- A nominal rate goes with nominal, inflation-inclusive cash flow
Mismatches are a frequent source of error and an easy target on cross-examination.
Cost of equity: the two common constructions
The build-up method
Most common for small and mid-sized private companies, because it does not require identifying a beta.
Risk-free rate. Typically the yield on a long-term government bond as of the valuation date, with a maturity matched to the expected life of the investment. It must be the rate as of the valuation date, not the current rate, which matters greatly for retrospective valuations.
Equity risk premium. The additional return investors require for equity over the risk-free asset, drawn from long-run market data or forward-looking estimates. The source and the vintage should be disclosed.
Size premium. Empirical data shows smaller companies have historically delivered higher returns, reflecting higher risk. Size premium data is published by recognized sources and stratified by decile or portfolio. Most private companies being valued are smaller than the smallest published portfolio, which is itself a consideration.
Industry risk adjustment. An adjustment reflecting the industry’s systematic risk relative to the market, positive or negative.
Company-specific risk premium. Everything else.
Modified CAPM
Starts with the risk-free rate plus beta times the equity risk premium, then adds size and company-specific premiums. Requires selecting comparable public companies, unlevering their betas to remove the effect of their capital structures, and relevering at the subject’s capital structure. More defensible where good comparables exist; more assumption-laden where they do not.
The company-specific risk premium
This is the most contested element in private company valuation, and the one that most often distinguishes a reasoned report from a conclusion reached backward.
It captures risks that market data does not: unsystematic, company-level risks a diversified investor could theoretically eliminate but a buyer of a whole private company cannot.
Factors commonly considered:
- Customer concentration. The most frequently significant factor. A single customer at 40% of revenue is a different risk profile from a thousand customers.
- Owner or key person dependence. Relationships, technical knowledge, pricing authority, and licensing held by one person.
- Management depth. Whether a second tier exists and is capable.
- Supplier concentration and supply chain fragility.
- Financial record quality. Audited, reviewed, compiled, or internal.
- Earnings volatility relative to industry.
- Capital access. Ability to borrow or raise equity.
- Geographic concentration.
- Litigation, regulatory, and environmental exposure.
- Product or service diversification.
- Lease and facility security.
- Workforce, including union status and key employee retention.
The weakness of the concept is that it has no published dataset. It is judgment, and judgment is attackable.
What makes it defensible is documentation of reasoning. A report that lists each factor, describes the subject’s specific condition, states the direction and rough weight of the adjustment, and arrives at an aggregate figure is far stronger than one that states a number and moves on. Reviewers and opposing experts look for exactly this.
Two failure modes to avoid: double counting a risk that is already captured in the size premium or the forecast, and using the company-specific premium as a plug to reach a target value.
Weighted average cost of capital
Where the valuation is on an invested capital basis, the cost of equity is blended with the after-tax cost of debt, weighted by capital structure.
Three decisions matter:
Which capital structure? Generally the structure a hypothetical buyer would employ, often an industry-typical structure, rather than the subject’s actual structure, which may be idiosyncratic. Valuing a control interest typically uses an optimal or industry structure; valuing a minority interest that cannot change the structure may use the actual one.
Cost of debt. The rate the subject could borrow at as of the valuation date, not the legacy rate on existing debt.
Tax effect. Debt is tax-deductible; the after-tax cost is used. For pass-through entities, the treatment requires care.
Pass-through entities
S corporations, LLCs, and partnerships do not pay entity-level federal income tax. Whether and how that benefit affects value has been debated for decades, with several competing models and a body of Tax Court decisions.
The practical requirement is consistency. If the benefit stream is pre-tax pass-through income, the rate must be constructed on a consistent basis. Tax-affecting or not tax-affecting the earnings changes the appropriate rate, and mixing the conventions produces a nonsense answer. The report should state which convention it uses and why.
Sanity checks
A defensible rate survives a few simple tests:
The implied multiple test. Invert the capitalization rate. A 20% cap rate implies a five-times multiple of the benefit stream. Does that multiple make sense against observed transactions in the industry and size range? If the implied multiple is wildly off market, either the rate or the benefit definition is wrong.
The reconciliation test. Does the income approach conclusion sit in a defensible relationship to the market approach conclusion? Large divergence signals a problem in one of them.
The internal consistency test. Is the growth rate embedded in the capitalization rate consistent with the growth assumed in the analysis, and is it sustainable in perpetuity? Long-term growth exceeding long-term economic growth is generally not sustainable and should be justified if used.
The buyer test. Would a rational buyer accept this return for this risk? A rate implying a 9% return on a single-customer, owner-dependent business fails common sense regardless of the arithmetic behind it.
FAQ
Why is my company’s discount rate so much higher than a public company’s?
Size, concentration, management depth, capital access, and illiquidity. Small private companies carry substantially more unsystematic risk, and buyers price it.
Can the company-specific risk premium be zero?
In principle yes, for an exceptionally well-diversified, professionally managed private company. In practice it rarely is, and a zero premium should be explained.
Does the discount rate change between valuation dates?
Yes. Risk-free rates move, equity risk premium estimates are revised, and company-specific risk changes with the business. A rate copied forward from a prior year without review is a defect.
Should I use a discount rate or a capitalization rate?
A discount rate for a multi-period projection, a capitalization rate for a single representative benefit stream. The capitalization rate is the discount rate less sustainable growth.
