When valuing a business, experts use various valuation methods, such as Discounted Cash Flows (DCF) analysis, comparable company analysis, market value, and asset-based methods. When using DCF method, one way to select an appropriate discount rate for the business is to use the built-up method.
+ Equity Risk Premium (ERP)
+ Size Premium
+/- Industry Risk Premium
+ Specific Company Risk
= Cost of Capital Discount Rate*
* Does not take into account for beta
- Risk-Free Rate (Safe Rate)
- The most commonly used measure is the 20-year yield on a U.S. Treasury Bond.
- Can consult Wall Street Journal quoted market yields on a 30-year bond with approximately 20 years of maturity left.
- Equity Risk Premium (ERP)
- Premium is needed for investors to participate in equity markets instead of long-term governmental securities.
- Many valuation analysts use a long-term horizon with the S&P 500 as their benchmark.
- This Premium is forward-looking and represents the anticipated incremental return on common stocks.
- Uses historical excess return on stocks over the long-term government bond income returns.
- The basic premise is that past ERP is a reasonable forecast for future ERP.
- Size Premium
- Size Premium = increased risk in small companies.
- These are presented for each of the 10th decile of the public securities market.
- Reflect the excess returns required on small securities.
- The increased risk maybe developed by many criteria related to the subject company to help determine the size premium.
- Industry Risk Premium (IRP)
- The amount investors expect the future return of the industry to exceed the return on the market.
- This amount is often leveraged for the industry beta.
- Company-Specific Risk Factors
- Final component of the discount rate.
- The most judgmental area of business valuation.
- Includes risks associated with the industry operated in as it relates to the economy.
- It also relates to the subject company’s risks, including management, market, and suppliers and customers’ concentration risks.