Build-up Capitalization Rate
A discount rate is the required rate of return an investor demands for investing in a business, measured in terms of the benefit stream under consideration, the perceived risks of making the investment, and the rates of return offered by alternative investments. A discount rate is used with earnings values for future periods.
A capitalization rate is a rate of return used with a single earnings value. It is the company's discount rate adjusted by a percentage reflective of expected future earnings growth based on the earnings stream with which it is used.
The "build-up method" is a way of establishing a discount rate by specifying components of "risk", and assigning a risk premium (an increase in the expected rate of return) for the magnitude of risk associated with each component. The "build-up method" as I have established it for SampleName Corporation is displayed below.
|Risk Free Rate of Return||4.5%|
|Equity Risk Premium||7.5%|
|Company Specific Risk Adjustment||2.0%|
|Net Cash Flow Discount Rate||20.0%|
|Net Income to Net Cash Flow Ratio||1.2|
|Net Income Discount Rate||24.0%|
|Net Income Capitalization Rate||22.0%|
|Net Income Capitalization Rate as a Multiple||4.5|
Assumptions & Notes
Risk Free Rate of Return. The risk free rate of return is defined as the rate of return an investor would accept on a security with no risk of loss by default. The rate of return displayed is the valuation date yield on a 30-year Treasury Bond with a 20 year maturity. For U.S. investments, Treasury securities are usually considered to be the safest investments available. Such a security establishes the risk free rate of return, as of the valuation date, with certainty.
Equity Risk Premium. The adjustment here is the extent to which equity investments have yielded an average rate of return in excess of Treasury securities over a long period of time. It is reasonable to expect that future equity investments will be expected and required to earn a similar higher rate of return to attract equity capital and to offset the reasonable expectation that an equity investment has higher risk than a Treasury security investment. The value displayed is the arithmetic mean of the historical public company data as compiled and established by Ibbotson Associates, Chicago, Illinois.
Size Premium. This adjustment reflects the extent to which investments in small companies have yielded higher average rates of return than large companies over a long period of time. The value displayed is the average rate of return publicly traded companies defined as "micro-cap. stocks" have outperformed large-cap. stocks as compiled and reported by Ibbotson Associates, Chicago, Illinois. Based on SampleName Corporation's small size, such a higher rate of return might reasonably be expected to be required to attract an equity investment in the company.
Company Specific Risk Adjustment. This adjustment reflects the extent to which an investment in SampleName Corporation might be expected to have a higher perceived risk than than an equity investment in a publicly traded stock as otherwise established by the build-up method. The value displayed was established based on attribute risk scoring as documented in the report section that follows.
Net Income to Net Cash Flow Ratio. The build-up method as otherwise established is indicative of a capitalization rate be used with net cash flow. To convert the rate for use with net income, I multiplied the rate by the relationship net income has to net cash flow. The value displayed is the ratio appropriate for the company based on adjustments made to the company's financial statements as required for valuation purposes.
Growth Adjustment. A capitalization rate is a rate of return used in conjunction with a single annual earnings value. To account for long-term average annual earnings growth, the discount rate (the expected equity rate of return) is adjusted downward to the extent the earnings value being capitalized is expected to grow. The adjustment here creates a mathematical equivalency that accounts for earnings which are expected to grow and the static earnings value being capitalized. The adjustment is a mathematical adjustment, not a risk related rate of return adjustment.
Net Income Capitalization Rate as a Multiple. A capitalization rate and price multiple are reciprocals. To display the capitalization rate as a multiple, I divided 1.0 by the capitalization rate.