Capitalisation rate v Discount rate
What is the difference between the capitalisation rate and the discount rate? Are they the same?
The capitalisation rate is the ratio of earnings to value. The inverse of the capitalisation rate is the earnings multiple. In the Capitalisation of Future Maintainable Earnings (FME) method, the multiple is applied against future maintainable earnings to arrive at the value of the business. Importantly the FME method assumes earnings will continue in perpetuity with minimal growth.
Discounted Cash Flow valuation method uses a discount rate. The discount rate is used to discount future cash flows to arrive at the net present value of a business.
What’s the difference?
The business valuer applies the discount rate against the expected future cash flows for each year in the future. The business valuer applies the capitalisation rate against only the expected earnings for next year.
The rationale behind using a capitalisation rate is that earnings in the business are assumed to be stable, predictable and not significantly growing.
If earnings aren’t stable or are significantly growing or not indefinite, then the discount rate and Discounted Cash Flow (DCF) method must be used.
Sometimes they converge
Under a DCF model, it might be plausible to assume that at some time in the future the earnings will stabilise. That is to say, the valuer projects earnings and earnings growth for a limited number of years, say five years. After five years earnings are assumed to plateau with minimal future earnings growth. The value of the future cash flows after five years’, the terminal value, is calculated using the capitalisation rate. In other words, after five years earnings are assumed to continue in perpetuity at the same level.
The critical difference is that in the discounted cash flow model, the business valuer builds growth into the expected cash flows (not the discount rate). Under the capitalisation of income method, the business valuer build growth (providing it is minimal) into the capitalisation rate.
Simon is a CA Business Valuation specialist, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.
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