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:
Specific Factors to Consider
In accessing the discount rate the following factors should be considered
Quality of Balance Sheet
Cash Flow Requirements
Indirect Financial considerations
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.