Michael Goldman & Associates, L.L.C. - Consulting
& CPA Services
|
|
|
Goldman's Critical Support - Winter 2001 Valuation Issues: Capitalization, Discounting, and Discounts
Valuation terminology can be confusing. In calculating the
present value of future earnings, when do you use capitalization rates and when
do you use discount rates? What's the difference between discount rates and
discounts? This article will define those terms and explain their different
uses. Capitalization and Discount Rates Discounting and capitalizing are variations of the same
theme – calculating today’s value of a benefit stream that will be realized
over an extended period of time in the future. We are all aware of the concept
that, thanks to inflation, a dollar in hand today is worth more than a dollar
that we receive ten years from now. Valuators use discounting to determine present value when
the future benefits are reasonably predictable from one year to the next, or
from one accounting period to the next. Valuation experts use capitalization, which is a simplified
version of discounting, when year-by-year projections are not as reliable and
the company can only project a straight-line trend over a longer period (see
chart). In this scenario, growth in future returns (as a percent) is estimated
in the form of one average annual compounded growth rate, so that the present value of the benefit stream (income or cash
flow) can be more easily derived. Capitalizing In the capitalization method of valuation, you divide a
base amount of return for a number of years
(such as an earnings or cash flow stream, in dollars) by a rate called
the capitalization rate. You implicitly assume that the return grows uniformly
from year to year, even though you realistically expect that it won't, because
it's difficult to predict the return accurately. The capitalization rate equals the subject entity’s cost
of capital minus the expected long-term sustainable
growth rate. Let's look at those two factors one at a time. 1. Cost of capital is, generally speaking, the expected rate of
return that the market requires to attract funds to a particular investment. A
market approach to the cost of capital would look at the rates of return for
investments with comparable risk profiles. As with all other market-based
assessments, cost of capital represents investor’s expectations relative to
the market as a whole. The higher the cost of capital, the lower the value of
the company. The components of the cost of
capital are (a) the “risk-free rate of return” currently being demanded by
the market, (b) a risk premium for the market as a whole, (c) a measure of
volatility of the entity being valued relative to the market as a whole
(referred to as “beta”), and (d) specific risk premiums attributable to the
entity being valued. The first three components are often available from
published statistics and market analysts such as Value Line. The fourth
component, company-specific risk premiums, are subjective and based on analysis
of the characteristics of the company being valued, such as: ·
Size ·
Relative volatility of returns ·
Leverage and capital structure ·
Concentration of customer base or key suppliers ·
Dependence on a small or inexperienced management team ·
Competition ·
Pending regulatory changes, lawsuits, environmental issues, etc. ·
Diversification of products, geography, etc. 2. Sustainable growth rate is the analyst's best estimate of the
normal growth of the company, based on economic, industry, and market
conditions. Discounting In the discounting method of valuation, each future
increment of return (a single year or accounting period) is estimated
specifically. The return for each year is discounted by using discount rates
based on the cost of capital. The valuator calculates the cost of capital using
the factors listed above. Discounting and capitalizing will produce the same result
if the expected growth rate of the benefit stream is assumed to be constant. Since constant growth rates in
perpetuity are generally not realistic, it is common to combine discounting and
capitalizing in a two-stage approach. For those periods where returns can be
projected with a reasonable degree of accuracy, each period’s benefits are
discounted using the cost of capital. Since each period is being evaluated
separately, growth is dealt with in the benefit stream (i.e., each period’s
assumed growth rate is factored into the calculation of what that specific
period’s benefit stream will be). Once the valuator has consumed the time
period of variable benefit projections, all benefits beyond this stream are
valued by estimating the benefit stream using a constant growth assumption and
then capitalizing the benefit stream using the capitalization rate. A good example of when to use both methods would be in the valuation of a high-tech company. During the early years the analyst may expect rates of growth that are variable each year. For example, the company may project no earnings for the first two years, good earnings in the third year, and then explosive growth in the fourth, fifth, sixth, seventh, and eighth years (see chart). These earnings in the first eight years would be discounted back to a present value using the cost of capital. If it is expected that after year-eight earnings will grow at a stable rate of 5% thereafter, the present value of that terminal earnings stream would be calculated by capitalizing that earnings stream using the cost of capital less the 5% growth rate.
© Michael Goldman 2001 For more information, please go to www.michaelgoldman.com Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.
|
Send mail to
michaelgoldman@mindspring.com with
questions or comments about this web site.
|