Factors to Consider When Choosing a Discount Rate
Main Factors to Consider
Their are countless factors to consider when accessing the appropriate discount rate. The overall consideration is how comfortable is a buyer likely to be with the following:
- The ability to meet or exceed the projections
- The value and marketability of tangible assets which could be recovered if the operations failed
- Cost to duplicate operations/ barriers to entry
Specific Factors to Consider
In accessing the discount rate the following factors should be considered
- Quality of earnings
- Consistency
- Portion created by recasting
- Cushion in margins to weather hard times
- Diversity of revenue base
- Aggressiveness of projections
Quality of Balance Sheet
- Are any assets under or over valued
- Receivables current & collectable
- Inventory obsolescence
- Level of net tangible assets
- Fair market value of assets
- Strength of,current ratio
- Degree-of-leverage
Cash Flow Requirements
- Magnitude of future capital expenditure requirements
- Working capital requirements
Indirect Financial considerations
- Barriers to entry
- Patents
- Diversification (product, customers, suppliers, region)
- Niche vs. commodity type product
Industry Considerations
- Outlook for industry
- Competitive environment
Looking at Pretax. EBIT. EBDIT. Cash Flow
While cash flow is used as the financial stream other financial streams can also be used such as pretax income, EBIT, EBDIT.
When reviewing the preliminary value these other measures should also be looked at as a sanity check. When comparing the earnings as measured by each of the above methods to value yields an unusually high or low multiple it may indicate that the value is inappropriate.
A typical case where pretax cash flow may yield a value that is to low is company that relies heavily on debt. A pre-debt cash flow analysis may develop what appears to be an aggressive value of 6 times cash flow with a discount rate in the mid teens. However this value may only translate into 1 1/2 times pretax income which may imply that the Company is undervalued. This potential undervaluation despite a low discount rate reflects the use of pre-debt cash flow when debt is integral to the operations. The Company may be able to borrow at 9% but we are discounting that debt at 15% resulting in a six point spread that the client loses.
Guidance on Setting Discount Rate
While establishing a discount rate is an art that is difficult to quantify attached are two attempts to categorize companies into risk categories by Dewings’s and Schilt’s.
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