What Does Discount Rate Mean?
The discount rate is a rate of return that is used in a business valuation to convert a series of future anticipated cash flow from a company to present value under the discounted cash flow approach.
The most common method to derive the discount rate is using a weighted average cost of capital approach which represents a weighted average of the after-tax cost of debt and the cost of equity where the weighting is based on a company’s target debt-equity ratio, measured at market.
A capitalization rate and discount rate are often confused in the determination of business value. They are different in the fact that a capitalization rate is applied to a single discretionary cash flow, whereby a discount rate is applied to a series of cash flows presented in a forecast. The capitalization rate is calculated by deducting a growth factor from the discount rate.
Divestopedia Explains Discount Rate
The discount rate of a business is closely tied to the riskiness of the operation and a company's ability to access capital. Although discount rates for any company can vary significantly, it is important for business owners to understand that, in general, discount rates will fall within the following ranges:
- 10%–15% for large multinational corporations with revenues greater than $1 billion. These businesses have relatively low risk profiles and can access large amounts of debt. Companies like Apple and Microsoft would fall into this range.
- 16%–20% for established upper middle market companies with revenues between $500 million - $1 billion. These companies have modest risk profiles. Smaller public companies or large private companies would fall into this discount rate range.
- 21%–25% for middle market companies with revenue between $50 million and $500 million. Companies in this range often carry risk of geographic, customer or product concentration. Access to capital is also still challenging.
- 26%–30% for companies in the lower middle market with revenue between $5 million and $50 million. Companies in this range are higher risk with limited debt capacity.
- 30%+ for early stage and start-up companies. These are typically venture capital type deals.
If you are preparing a valuation using a discount cash flow approach and your discount rate is significantly higher or lower than those suggested above, you should definitely revisit your assumptions because this may raise a red flag for potential acquirers regarding your ability to accurately assess the risks associated with your business.