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The discount rate can be defined in several ways. For purposes of this post, the discount rate will be defined as it relates to small and medium sized businesses (SMBs) and the Discounted Cash Flow (DCF) valuation method.
As it applies to a business investment appraisal, the discount rate is that interest rate which is applied to the DCF business valuation method in order to determine what the expected future business income will be expressed in terms of present day dollars (or current market value). This measurement is always less than 1.0 and will vary depending on the cost of capital and the expected time horizon between when the investment is made and when the investment will begin to deliver positive cash flow.
The discount rate in the DCF takes into account the time value of money and the risk and uncertainty of future cash flows. In fact, the greater the uncertainty regarding future cash flows from the business, the greater the discount rate will be.
Discount Rate Equation
In order to calculate the discount rate (also called the discount factor or present value factor), the following formula is used:
1 / (1+r)^n
Where r is the required rate of return (or interest rate) and n is the number of years between present day and the future year in question.
How to Apply the Discount Rate to Evaluate a Business Investment
The discount rate is used to calculate the DCF Valuation of a business and the formula is:
|PV = CF1 / (1+k) + CF2 / (1+k)2 + ….. [TCF / (k – g)] / (1+k)n-1|
PV = Present Value
CFi = Cash Flow Year i
k = Discount Rate
TCF = Terminal Year Cash Flow
g = Growth rate assumption in perpetuity beyond the terminal year
n = Number of periods in the valuation model (including the terminal year)
Ultimately, the DCF valuation will produce a value of the business (the Present Value of the future cash flow while applying the discount rate) which then can be compared to the asking price of the business.
If the DCF Valuation exceeds the asking price, generally speaking the investment is considered to be a good one. Alternatively, if the DCF Valuation is less than the asking price, the asking price may be too high.
The Discount Rate is only one important part of the Discounted Cash Flow valuation method. Knowing that the projected cash flow from a business investment is accurate is critical to a proper evaluation. If the projected cash flow is exaggerated, intentionally or otherwise, the value of the business investment can be dramatically skewed. A prudent investor should scrutinize projected cash flow carefully.
Similarly, the other assumptions in the DCF Valuation must be considered carefully. Each factor has a unique impact on the ultimate computation.
The discount rate used in the DCF Valuation method is only one way to evaluate whether a business for sale is properly priced. When used in tandem with other business valuation methods, it can help a business buyer make a sound decision about the asking price of a business for sale.