3.04: Discount rates
The fair market value of a business enterprise is sometimes calculated using a discounted cashflow method, (DCF) especially where the business is growing fast, unevenly or has a limited expected life.
The discount rate, when used in this way, has a very significant impact on the valuation conclusion and needs to be developed with great care. Unlike capitalization rates, discount rates are not translated into multiples.
Discount rates have a significant impact on the valuation conclusion.
Discount rates are developed after a consideration of the same factors as the capitalization rate. However, their use is different. A cap rate is generally applied to a normalized cashflow for a stable business for a single year (albeit in a range) while a discount rate is applied to projected cashflows for several years into the future. The discount rate is particularly useful if the business will require significant injections of capital at various times in the future; it allows the user to calculate the present value of the business or project knowing that there could be significant variations in the net cashflow from year to year. In investment decision making, it allows the user to set a hurdle rate, or required rate of return, and only approve the project if the calculations provide a positive present value at that discount rate.
Contact MVI if you would like a better understanding of how discount rates are determined or used, and/or which factors are the most influential.