When appraisers refer to a discount rate, they are, generally speaking, referring to the rate used to discount the expected future income stream to present value. The discount rate is intended to be equal to the rate of return required to induce an investor to invest in the business.
The rate of return required by the investor is directly associated with the perceived risk of being able to get a return on his money by investing in an asset. It is perhaps easiest to think of a discount rate in terms of a menu of options that an investor has available. For example, if that investor wants to invest in an asset with very little risk, such as a US Treasury bond, he will only get, and only require, a small rate of return, perhaps in today's marketplace on the order of one percent. If, on the other hand, he is willing to accept a greater amount of risk of losing all his investment by putting money in a startup company for example, he will want a greater potential reward for assuming that risk.
For What an Investor is Willing to Pay
Accordingly, he will require a greater rate of return, which has an inverse relationship with the price he is willing to pay. This means that, all else being equal, he is willing to pay less for a riskier asset. By paying less up front, if the projected cash flows are actually achieved or exceeded, he has increased his return on the investment, or if the investment proves fruitless, he has lost less on that particular investment. An investor is only willing to pay for an expected income stream that exceeds his required rate of return.
The amount of the future income expected, and the risk associated with the expected future income are inseparably linked. This means, that at least in part, how aggressive or conservative the person preparing the projection of future income is, drives how the risk surrounding those expectations are viewed. For example, (setting aside arguments of inflation), there is relatively little risk that a holder of a US Treasury bond won't be paid the required interest or return associated with that bond. In contrast, the risk of achieving "pie-in-the-sky" net income projections for a new start-up business can be very risky, as any number of things could go wrong, and sometimes only one of them has to go wrong in order to kill the company, let alone lead to a failure to achieve such lofty projections.
The Buildup Method
One popular method for calculating the discount rate is known as the buildup method. When calculating a discount rate under the buildup method, the appraiser compares the business in question to various other types of returns that are observable in published data and attempts to add various factors until he reaches the appropriate amount of risk. This method is based on the principle alluded to previously, that an investor would require a greater return on assets that are more risky.
As an example, let's say an appraiser is valuing a small fast food restaurant. She knows that the fast food restaurant has more risk than a long term government bond, effectively recognized as a risk free rate. So the first rate she observes is the rate on long term government bonds as of the valuation date. She also knows the business generally has more risk than corporate bonds, so she also adds the risk premium, or the amount over and above a risk free rate, that can be observed for corporate bonds. Then she will add an equity risk premium, or the amount necessary to equal the returns on large, publicly traded company stock. Since the small closely held company is more risky than a large, publicly traded company, she will often add a size premium, or the amount necessary to compensate the investor for additional risk associated with the small size of the company. Since return data can be observed for certain industries, which may be higher or lower than the risk data for the market as a whole, she will also look to see whether an industry risk premium (or discount) is necessary.
Company Specific Risk Factor
While the data used in a build-up method to this point can be readily observed, the next factor is highly subjective, and often the source of controversy in valuation disputes. Using her experience and judgment, the appraiser typically adds, or subtracts an additional risk premium known as a company specific risk factor. The intent of the company specific risk factor is benign, it being a "catch all" to adjust for additional perceived differences between the risks the company faces and those faced by the factors accounted for with the risk free rate, the corporate bond premium, the equity premium, the size premium and the industry premium. The company specific risk premium may also include a factor based on the risk inherent in the income projection model. However, appraisers can disagree sharply on the amount of a company specific risk factor based on their perception of the risk the company faces.
Another popular method for calculating the discount rate is known as the capital asset pricing model. The approach uses the beta, which is a measure of stock price volatility, for comparable publicly traded stocks to calculate a risk premium that is added to the risk free rate. At times, an additional factor for company specific risk is also added to this amount to arrive at an ultimate conclusion of the discount rate. In the author's opinion, the capital asset pricing model is not generally suited for most small businesses because it assumes that the publicly traded companies used to calculate the beta are comparable to the small business in question, usually a difficult argument to make.
What to Look for When Evaluating a Discount Rate
Without an in depth knowledge of discount rates, it may be difficult to make a compelling argument regarding a change to the objective aspects of a discount rate. However, there can be plenty of wiggle room in a discount rate depending on the how much of a company specific risk premium the appraiser, in her judgment, thinks is appropriate. Keep in mind that a discount rate has an inverse relationship to value, meaning the higher the discount rate, the lower the value and vice versa. In order to make an argument for either a lower or higher discount rate, you need to be able to show why the company is more or less risky than the alternative investments. Focus on the subjective aspect of the discount rate and show the appraiser why she over or under estimated the company specific risk premium because of undue reliance on one or more factors influencing her decision.
Once both variables, the future income stream and the discount rate, have been determined, it becomes simple mathematics to calculate the value under an income approach. However, as can be noted in the above discussion, there can be a multitude of assumptions that go into determining value under an income approach. The user should understand all the assumptions that go into the appraisal and make sure that those assumptions have a basis in reality for the value to have any credibility.