Determining the discount rate may be the single most important activity in any valuation project, as well as the most controversial one, and the focus of most discussions among the team and the client. There are well-known standards and best market practices for the discount rate estimation, in addition to defined practices specific to each corporate finance team in all firms and countries. Nonetheless, how one team comes to estimate one or more parameters underlying the discount rate most probably varies in every project. It may happen with the blink of an eye, and without much explanation or rationale. To speak openly, you may fall victim of your project manager's uncalled-for moment of creativity, as well as receiving an unpleasant call from your unhappy client (the same client who had agreed on the methodology in an earlier project, but has since then had a change of heart, curiously after recording a drop in financial results).
Truth be told, the act (or art, some say) of estimating the discount rate generally goes hand-in-hand with serious migraines, confusion and yet more headaches, as you will find yourself updating it countless times until you have reached that perfect number, satisfactory to most of the people involved (yourself excluded, ça va sans dir). On top of that, even after all of these changes, your valuation may well be the same as the one you had in your original draft. Needless to say, it is a very fulfilling process.
After this inspiring introduction, let's take a look at the standard methodologies used to estimate the cost of equity ("Ke"), cost of debt ("Kd") and, consequently, the weighted average cost of capital ("WACC"). We will explore the common alternatives applicable for the estimation of each individual parameter underlying the different costs of capital. We also include our Excel template for the discount rate estimation at the end of the article.
Cost of equity
To value a company or a project using an equity-side approach, you must estimate the Ke to discount the related free cash flows to equity ("FCFE") or dividend streams. As per the capital asset pricing model ("CAPM"), the cost of equity is calculated as follows:
Ke = Rf + β x (ERP - Rf) + RP
Let's look at the individual parameters in detail.
The first parameter is the risk free rate, Rf. Government bond yields are generally taken as proxy for the risk-free rate, considering their relatively low default risk (depending on the government, of course). If the company or project you are valuing is located in a developed country where government bonds are issued with regular frequency, consider the yield of the government bonds issued in that country. The most common maturity considered for companies is 20 years; for projects, choose the maturity of the bond depending on the duration of the specific project (e.g. 5, 10 or 20 years).
In addition to the bonds' maturity, you will need to decide whether to consider the spot yield (i.e. as at the valuation date) or an average yield (e.g. 6 or 12 months). The 12-month average yield is probably the most commonly used; however, you may want to consider the spot rate in case the yield has exhibited a significant up or downward trend in the short-term. A movement in the risk free rate is generally accompanied by variations in other parameters, such as the equity risk premium ("ERP"): to give an example, the fall of risk free rates has been observed during financial crises, with Central Banks all over the world lowering interest rates to stimulate economic recovery; in parallel, an increase in the ERP would be expected, reflecting a spike in the general level of risk and, consequently, the yield required by equity investors. This is to say, it may not be unusual to see a fall in the discount rates during periods of crisis, as the movement in one parameter may not fully offset that of another: it will be your call whether to adjust your estimated discount rate by considering a higher risk premium.
If the company or project you are valuing is located in a less developed country, where local government bonds are not issued with regular frequency, you will need to follow a build-up approach, considering the yield of foreign government bonds (e.g. US Treasury bonds) and summing this yield to the relevant country risk premium ("CRP"). A common source of the CRP is NYU Professor Aswath Damodaran's research (link to January 2021 CRPs).
In addition, if the foreign government bonds considered are denominated in a different currency compared to that in which your company or project carries out most of its business, you will also need to add the so-called inflation differential, i.e. the difference between the local long-term inflation rate (g) and that of the foreign country considered. Commonly used sources of long-term inflation include the Economist Intelligence Unit ("EIU") and the International Monetary Fund ("IMF").
If you have access to forward curves (downloadable from the Bloomberg terminal), you may also consider estimating a different cost of equity for each discount period based on the expected evolution of the risk free rate. This may be relevant in case the Central Bank has announced plans to increase interest rates in the near future.
The second parameter is the beta, β, or the measure of how a stock moves compared to the relevant market index (i.e. positively, in line or inversely related), calculated as the slope of the regression line between the movement of a stock's price and that of the relevant market index. The beta is commonly estimated on a market participant basis, i.e. based on the average betas of listed comparable companies, levered for financial institutions and unlevered for non-financial institutions. The typical average considered is of either 2 or 5 years, depending on your team’s best practices and the current market cycle: considering a longer horizon during periods of crisis and/or of high volatility helps to smooth out peaks and troughs.
If you are valuing a non-financial institution or a project, you will need to relever the average unlevered beta based on the following:
gearing ratio ("D/E"), generally equal to the average gearing ratio of the comparable companies. This average should be consistent with that considered for the unlevered beta (i.e. 2 or 5 years). In general, it is good practice to compare the average market gearing ratio to that of the specific company or project you are valuing: keeping an eye on the historical average gearing, as well as future capital funding plans will help you assess whether it is more relevant to consider a company-specific gearing ratio (in case, for example, the management of the company is adverse to debt) instead of the market participants’ ratio (which may be seen as the industry's optimal or target level). Furthermore, in case you are valuing a project with an expiry date, you should consider the project-specific average gearing ratio between the valuation date and the project’s expiry date.
corporate tax rate (Tc), corresponding to that of the country in which your company or project is located, as at the valuation date.
The estimation of the beta is definitely the most time consuming part of the whole process. First and foremost, it is fundamental to obtain inputs directly from your client regarding the specific business sector in which they operate and who the key market players are. Remember one thing: your partner may sell you and your team as the ultimate market experts, but it is rare for a consultant to know the market as well as or better than their client, so be humble and try to leverage their knowledge as much as possible. You will make the client happy and learn plenty in the process.
To identify listed peers, in addition to leveraging on your client's expertise, running a simple Google search has proven to be the most effective way to go. Once you have your preliminary list of competitors, carry out further research on the Bloomberg terminal (use the function "RV", but don't depend on it, as it doesn't always give out relevant results) or S&P Capital IQ (if your firm is too cheap to pay for Bloomberg). Once you have completed your analysis, download the peers' betas and compute the average to include in your discount rate estimation. In case you don't have access to either platform (i.e. if you do not work in an advisory firm), Yahoo! Finance publishes the 5-year monthly beta of listed companies. Worst case scenario: Prof. Damodaran publishes the average betas by industry (link to January 2021 data).
The third parameter is the equity risk premium, ERP. Although some Big 4 firms estimate their own ERPs (in either a scientific or a more “subjective” fashion), these typically do not differ significantly from the widely-used and publicly available ERPs sourced from the research of NYU professor Aswath Damodaran (link to January 2021 ERPs). The difference between the ERP and Rf is the market risk premium ("MRP"), which represents the additional return that equity investors require to invest in equity instruments as opposed to risk-free investments. A common source of MRPs is the publicly available annual survey led by IESE professor Pablo Fernandez (link to 2020 paper).
The fourth parameter is the risk premium, RP. Whether to add premiums or not to your cost of equity estimate really depends on your team’s best practices. When valuing micro- and small-cap companies, you may want to consider a size premium, which is commonly sourced from the research published by Ibbotson or Duff & Phelps. It typically varies between 0.5% and 4%, but can go as high as 10%.
In case management's financial projections appear to be overly optimistic compared to historical financial results and expected market trends, you may wish to consider a projection risk premium. No need to include a premium, however, if you are sensitizing management's forecasts (e.g. reducing the annual growth rate of projections) and performing your valuation based on these revised projections. Remember: either increase your discount rate or decrease financial projections to reflect additional risk in your valuation; doing both would lead to a double-counting of the risk and would wrongly penalize the company or project your are valuing.
In case you are valuing a project that is currently under construction, but is expected to commence operations during the forecasting period, it is common to see a higher risk premium being applied for the construction period as compared to that considered for the operational period. The downside to this is that you will be discounting the cash flows expected during the construction period at a higher discount rate: these cash flows are most likely going to be negative, considering that significant capex will be undertaken and the project is not operational. Ceteris paribus, this will have a positive impact on your valuation. Again, whether to consider a higher risk premium for one project phase as opposed to another depends on your team’s standards. To be ultra-conservative, you may instead decide to apply a discount factor of 1 for the years with negative cashflows, disregarding the time-value of money and taking the full impact of the future negative cashflows on your valuation.
If you are valuing a loans portfolio, you may want to add a risk premium to discount the expected cash flows related to non-performing unsecured exposures, which carry a higher risk of recovery compared to non-performing secured exposures and, of course, performing loans.
NB: if a company or project generates revenues or cashflows in more than one country, how is this reflected in the estimation of the cost of equity? You will need to blend the following parameters estimated for each country, i.e. calculate the weighted average based on their individual contribution to the company or project’s total financial results or cashflows: 1. Inflation differential 2. CRP 3. Corporate tax rate (Tc) 4. ERP Most commonly, the single countries’ contribution may be expressed as a percentage of total revenues or free cash flows generated by the company or project, and may be estimated as at the valuation date or as an average across the projection period.
Cost of debt
Kd may be based on the specific cost of debt capital funding received by the company or project you are valuing, i.e. the average interest rate paid for loans and other debt financing as at the valuation date, or across the projection period.
To estimate the cost of debt on a market participant basis, sum the risk free rate and the average debt spread of companies operating in the same industry and having the same rating. Again, you may turn to the valuations guru Prof. Damodaran, who publishes the default spreads per interest coverage ratio and rating (link to January 2021 data).
If you have access to the Bloomberg Terminal or S&P Capital IQ, you can download the effective interest rate of the peers considered in the beta estimation, and calculate the average. Alternatively, you could also consider the debt spread of corporate bonds issued by companies operating in the same sector and with the same rating as the one you are valuing (if your company is not rated, you may want to stick with a rating of BBB or lower, to be conservative) and with a tenor consistent with the risk free rate (i.e. typically 20 years).
Remember that the Kd estimated with the above methods is pre-tax. To arrive at the post-tax cost of debt, apply the relevant corporate tax rate (Tc) as follows:
Post-tax Kd = Pre-tax Kd x (1 - Tc)
WACC
When valuing a company or a project using an asset-side approach, you will consider the WACC to discount the related free cash flows to the firm ("FCFF"). Very simply, the WACC is calculated as shown below:
WACC = Ke x E/(D + E) + Pre-tax Kd x D/(D + E) x (1 - Tc)
For consistency, the weights applied to the different costs of capital should reflect the same capital structure considered in the estimation of the cost of equity (based on the average gearing ratio).
We hope you found this article useful. Make sure to download our Excel template for the discount rates estimation:
In the 'Input' tab you can select/update the key assumptions on valuation date, tax rate, risk free rate, CRP, risk premiums and more.
The 'Peers' tab assists you in the estimation of the unlevered beta and gearing ratios:
The tax rate updates automatically when you select the country in which the peer company is headquartered.
Check for free float (% total shares outstanding) is included.
Manually insert the levered beta, market cap and total debt of the peer companies.
The 'Kd' tab assists you in estimating the company-specific cost of debt, based on forecasted debt financing and related funding costs.
The 'Tax' tab includes the latest available tax rates for all countries and regions (source: KPMG).
The 'ERP' tab includes the latest available ERP for all countries (source: Prof. Damodaran).
The 'CRP' tab includes the latest available CRP for all countries (source: Prof. Damodaran).
The 'Inflation' tab assists you in calculating the inflation differential required for the local risk-free rate build-up. We suggest you have a look at our g template in the Downloads & Links section of our website, in which you will also find the IMF's latest inflation rate projections by country.
Lastly, the 'WACC' and 'Ke_FSI' tabs provide the output: all parameters are already linked to the relevant tabs, except for the risk free rate, which you must insert manually. Use the 'Ke_FSI' tab when valuing financial services firms.
For questions or clarifications, feel free to reach out. Thanks for reading, and good luck!
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