Deriving discount rates for business valuation

ShaneSr (27/M/Tampa, FL) 1/10/00 1:49 pm

Free estimates are available from Zack's consensus estimates (from Zacks.com; Microsoft investor also has them with VERY good (free) company reports). The estimates are for EPS growth. The long term growth rates for the company and industry are also provided. You have to multiply the estimates by the shares outstanding and adjust the estimates yourself for effictive taxes, interest, etc. to get to EBIT. It's usually straight forward, especially using quartly income statements as guides. The Grabowski King study appeared in the Sept. 1996 Business Valuation Review - New Evidence on Size Effects and Rates of Return

wayne_yang.geo 1/11/00 1:50 pm

>>> Why wouldn't Copeland, Koller, and Murrin argue for a 20-year T Bond?

As you know, most of the liquidity in long-term Treasuries is at the 10-year and 30-year parts of the yield curve, since the government's long-term debt issuance is primarily in those maturities.

>>> Also, could you suggest some industry specific industries?

A lot of the Wall Street firms provide industry-specific indexes (i.e. the Merrill Lynch Technology 100), so you can check with any relationships you might have for historical data.

Otherwise, you can also comb through some of the traditional data providers: S&P Sector Scorecards: http://www.spglobal.com/sector-scorecard.html Standard & Poor's Indices: http://www.spglobal.com/ssindexmain.html Wilshire Indexes: http://www.wilshire.com/indexes/wilshire_indexes.htm http://www.wilshire.com/indexes/target.htm Best Regards, Wayne

numbacruncha2 1/10/00 2:07 pm

A brief note... If you're using Ibottson data, I believe he uses 20-yr T-bonds. The reason for it, I believe, is because of its statisical significance compared to the 10-yr and 30-yr.

bxp15 1/10/00 12:31 pm

First of all, I would like to thank everyone for their generous replies to my prior posting. I'm quite pleased that this club is frequented by thoughtful persons. The fact that the internet is being used for something intelligent is also refreshing.

Wayne Yang.geo suggested a 10-year Treasury Bond serve as a "risk free" rate, as opposed to a 30-year Treasury Bond. This point is well taken; isn't the 30-year Treasury Bond contract the one with all those bizarre delivery options? Why wouldn't Copeland, Koller, and Murrin argue for a 20-year T Bond, instead of a 10-year, as a discount rate basis though? Also, could you suggest some industry specific industries? Right now, I am referencing Ibbottson & Associates data, which seems to be widely accepted in the industry and by the court system. It does not appear to offer much help in constructing discount rates outside of company capitalization or sales volume factors though.

ShaneSr offered some very interesting comments about how to avoid the build up method entirely, which I would like to further explore. I must ask for further details though. What is a good source for consensus long-term growth rates by industry? Are these projections usually based upon P/E multiples or some form of EBIT ratio derivative? EBIT data and projections has proved elusive to me, especially since my department does not subscribe to any paid online research services.

Aren't Grabowski and King with PriceWaterhouseCoopers? Did they publish some text about their risk premium research?

I'm not sure that I am prepared to deal with ShaneSr's modified build up model yet. It sounds like a modified WACC analysis with a lot of corporate lending capital adjustments. Since I don't have a lending background, this one is probably beyond my current abilities. Thanks again for the replies.

ShaneSr 1/10/00 9:45 am

BXP, BXP,

I am in M&A for �mid-size� private companies and apply discount rates all the time. I actually use somewhat of a market approach to derive the discount rate. I select public peers in the industry, project the EBIT for the companies over 5 years using consensus EPS estimates and consensus long-term growth rates. I then compute the implied discount rate based on the public company's business enterprise value.

Step 2 is I adjust the DISCOUNT RATE for size risk premium (using the formula derived from a study by Roger Grabowski and David King that has an R2 of 91%).

Step 3 is I apply that discount rate to the subject company. I then apply a liquidity discount (typically about 20%) to the indicated VALUE. I do not apply a control premium.

I have found that most companies fall in a range of 17% to 23% before adjusting for liquidity (the size of the companies I deal with are $10 million to $100 million). Capital/Asset intensive companies are typically towards the lower end of the range. I use this approach mostly as a sanity check, although it may influence my value conclusion from time to time.

I don't use the traditional build up method. The only other similar method I use is a leveraged model - very useful for financial buyers (such as private equity groups). I estimated required returns for various forms of financing � term debt, unsecured notes, seller notes, mezzanine financing, preferred equity, common equity, etc. I then �build up� as much debt as I think is realistic, given the balance sheet and cash flow projections. I then back into the value based on required returns for left over equity and estimated value upon the exit in 3 � 7 years. There are a lot of inputs into this and it requires perhaps the highest level of financial sophistication among the valuation methods (I think). It�s also the model a financial buyer would look at, so it�s accurate (for financial buyers) if you do the research. Hope this helps! Shane Senior

wayne_yang.geo 1/8/00 12:33 pm

Hi, BXP, Copeland, Koller and Murrin argue for the use of the 10-year Treasury in their book Valuation. The 30-year tends to be more sensitive to unexpected changes in inflation and C,K&M also argue that there is somewhat more liquidity in the 10-year. On the issue of market risk premium, they use the geometric risk average for the return of the S&P 500 over U.S. long-term bonds over a specified period of time. You could similarly look at several other indices that might be relevant to the specific company you are analyzing, i.e. using industry-specific indices and company-size oriented indices (such as the Russell 2000 to find a market risk premium for a small cap company). Best Regards, Wayne

bxp15 1/8/00 4:28 am

I usually use a 20 or 30 year U.S. government Treasury Bond as my "risk free rate". I'm getting into trouble after adding equity and small-cap premiums. We like to make further adjustments to the discount rate on the basis of the industry and company characteristics. I can't seem to find anything particularly scientific about making those types of judgements.

amitm_99 1/8/00 1:55 am let us start that discussion informally... i believe for normal businesses the discounting should base itself on govt treasuries + inflation, looking forward to your comments on the same

bxp15 1/5/00 5:21 am Are there any other business appraisers out there? I'm interested in new ideas about deriving discount rates.