We will address the following two questions we ended part 1 with:
1. The influence of our fair rate of return/discount rate ( 15% in example ) has on the valuation, or how we determine the correct rate.
2. How long we assume the company will exist (three years in the example).
In plain language the rate of return or discount rate is the rate that a rational investor will expect to earn if he / she would invest their money in your business or in our example in Company A. Off course in many valuations there is not an actual investor wanting to invest in the business, however we still use this logic. To determine the fair rate of return we use the Capital Asset Pricing Model (CAPM) :
E(Ri) = Rf + Beta(RPm) + RPu
- E(Ri) is required return on security i
- Rf is the risk-free rate
- Beta is the influence the general market risk has on the specific company
- RPm is the general market risk premium
- RPu is the premium due to company specific risk
This may seem complicated, but fear not, I will explain.
The risk-free rate (Rf) is the rate of return an investor can expect when investing in an investment that carries no risk (all investments actually do have risk, thus we are talking hypothetically). Usually a valuator use the 10 year government bond rate for this. Let’s say in our example the 10 year government bond rate is 8%. You can find the actual bond rates for South Africa at: https://www.resbank.co.za/Research/Rates/Pages/CurrentMarketRates.aspx
The general market risk premium is the added return for additional general risk in the market. This is where the judgement of the valuator plays a role - this can be a subjective consideration. For example if the economic forecasts (say based on political events etc.) is bleak the risk for the investor is greater. Thus the investor would expect more return to compensate for the additional risk. Let’s say we add 5% return for general market risk.
However the general market risk may not have the same influence on all industries or types of businesses. This is where the Beta variable plays a role. It may be that when economic conditions are bad it is actually good for some businesses and bad for others. For example, if the economic conditions are bad people may be under financial stress and shop more at Shoprite (low cost grocery store) and less at Woolworths (high-end grocery store). So in this case bad economic conditions my be good for Shoprite and bad for Woolworths. The Beta variable can have a value between -1 and 1. With a value of -1 it means that whatever the general market risk premium is, it is has the opposite effect on the business. If the market risk premium is 3% then it actually lowers the rate the investor will expect (E(Ri)) by 3%, since -1 x 3% = - 3%. Intuitively it means say bad economic conditions are good for the specific company (Shoprite in example above). On the other end of the scale a Beta of 1 will add the full impact of the market risk premium to the business. The Beta value can also be anything else between -1 and 1. For example 0 would mean the market risk premium has no influence on the business. The decision on which Beta to use is again one where the valuator will use professional judgement, experience and if available comparable market data. Let’s say in our example the Beta is 0.6.
Lastly the company specific risk (RPu) is the what it says, the risk specific to this company. There may be a number of risk factors specific to a company, for example an inexperienced management team may cause the investor to take on more risk and thus expect for return. Let’s say in our case the company specific risk is 4%.
Now, to calculate our example’s required return / fair rate of return:
E(Ri) = 8% + 0.6 (5%) + 4% = 15%
If you now refer back to Part 1 of our example it will be clear that a higher rate of return will make the value of the business smaller because we discount each future profit back to present value by dividing with (1 + rate of return) to the power of the relevant number of years.
Which brings us to our second question - how long the company will exist or the window period. We can expect the business to exist a certain number of years - again this is based on professional judgement and can be a subjective decision. In many cases there is no clear reason to expect that the business will only exist a certain number of years, but it may be that you are working with a clear exit strategy of say 5 years. Normally I would select 10, 15 or 20 years as a window period. In our example we used 3 years for simplicity.
Author: Chris Herbst