How to Calculate Discount Rates for Business Valuation
Business valuation is a critical step in understanding the worth of a company, especially in mergers, acquisitions, or strategic planning. One essential aspect of valuation is determining the appropriate discount rate, which converts future cash flows into present value. This article will explore how to calculate discount rates for business valuation, ensuring accuracy and relevance for small and mid-sized businesses.
What Is a Discount Rate?
A discount rate is a percentage used to determine the present value of future cash flows. It reflects the risk associated with the business and the expected rate of return. In business valuation, a higher discount rate is applied to riskier businesses, while lower rates are used for stable companies with predictable cash flows.
The discount rate plays a key role in the Income Approach to valuation, where future after-tax discretionary cash flows are discounted back to present value. This allows a business owner, investor, or buyer to assess the true value of a company today, based on future financial projections.
Why Is the Discount Rate Important?
Understanding how to calculate discount rates is essential because it directly impacts the value of the business. If the rate is too high, the company may be undervalued, leading to lost opportunities. If too low, it may inflate the company’s worth and create unrealistic expectations for buyers or investors.
For small and mid-sized businesses, calculating an appropriate discount rate involves considering a variety of factors, such as market risk, company-specific risk, industry conditions, and economic factors.
How to Calculate Discount Rates
There are various methods to calculate discount rates. Here, we’ll break down the common approach used in business valuation, based on the Weighted Average Cost of Capital (WACC) and cost of equity calculations.
Weighted Average Cost of Capital (WACC)
WACC is the weighted average of a company’s cost of debt and cost of equity. This method reflects the overall return required by all investors—both debt holders and equity holders. Here’s a breakdown of the key components:
- Cost of Equity: The return required by equity investors, accounting for risks specific to the business. It’s often calculated using the Capital Asset Pricing Model (CAPM).
- Cost of Debt: The effective interest rate a company pays on its debt. This rate can be adjusted for the tax benefits of debt financing.
1. Cost of Equity Using the Build-Up Method
The Build-Up Method is used to calculate the cost of equity, an alternative to the Capital Asset Pricing Model (CAPM). The Build-Up Method adds various risk premiums to a base rate, such as the risk-free rate, to arrive at the total cost of equity. The base rate represents a risk-free investment, such as government bonds. From there, several premiums are "built up" to reflect additional risks faced by the business.

Using a build-up method, the WACC can be calculated as follows:
- Risk-Free Rate (Canada): 3.50%
- Equity Market Risk Premium (Canada): 5.20%
- Small Size Risk Premium: 10.73%
- Industry Specific Risk Premium: 4.0%
- Company-Specific Risk Premium: 5.00%
By adding these components, the cost of equity is calculated at 28.43%. The cost of debt, adjusted for tax, is 6.75%. Using a 70% equity and 30% debt capital structure, the WACC is determined to be 21.93%, reflecting the higher risks associated with a specific business and industry.
This method is commonly used calculating discount rates for small, private companies where public company data is either unavailable or inappropriate to use due to differences in size and market conditions. The Build-Up Method allows for a more tailored approach, incorporating the unique risks of each business.
2. Cost of Equity Using CAPM
To calculate the cost of equity, a widely used method is the Capital Asset Pricing Model (CAPM). CAPM considers the risk-free rate (usually based on government bonds), the equity market risk premium, and the company’s beta (a measure of how the company’s stock price is expected to move relative to the market).
In smaller, private businesses where stock price data is not available, the beta can be adjusted based on comparable public companies. Additionally, a size premium is often added for smaller businesses, reflecting the increased risk they typically face compared to large corporations.
3. Company-Specific Risk
A key factor in calculating discount rates for small businesses is the company-specific risk premium. This accounts for unique risks that may not be reflected in market data, such as:
- Dependence on key personnel
- Customer concentration
- Industry volatility
- Economic conditions specific to the business’s geographic location
Common Mistakes in Calculating Discount Rates
While the process may seem straightforward, there are some common errors to avoid when calculating discount rates for business valuation:
- Ignoring Company-Specific Risks: Failing to account for unique risks can lead to an undervaluation of the business.
- Overlooking Market Conditions: A company’s discount rate should reflect current economic and industry trends. Ignoring macroeconomic factors, such as interest rates or inflation, may distort the valuation.
- Using Inconsistent Assumptions: Ensure that the assumptions made in your financial forecasts are aligned with the discount rate used. For example, if your revenue forecasts are optimistic, you should adjust your discount rate to reflect the increased risk.
Discount Rate Calculation Summary
Calculating the right discount rate is crucial for accurate business valuation, especially for small and mid-sized companies. By understanding how to apply WACC, CAPM, and company-specific risk premiums, business owners can make informed decisions about their company’s value.
If you’re looking for expert help with your business valuation, Troy Valuations specializes in determining the fair market value of companies, using proven methodologies like the income approach and discounted cash flow analysis.