What discount rate do you use in your valuations?

arya180:

This is where valuation is obviously more of an art than a science. Talking about the right discount rate is always BS because people invariably have an idea of what they want the valuation to be and end up changing the rate to accomodate their number. Because of this, I usually treat the discount rate as an output instead of an input and ask myself if it makes sense among industry peers. If so, your work is done.

Calculating discount rates is not where "valuation is more of an art than a science." This is what poor analysts tell themselves when they're too lazy to understand what they're actually doing. I'm not saying the discount rate calculation is ever precise, i.e., that one can, with complete certainty, determine future cash flow volatility. What I'm saying is that there are better approximations, worse approximations, much better approximations and much worse approximations.

To respond to the OP's question - One could use the same discount rate when evaluating a set of comparables since, in the long run, the riskiness of their operations should be identical insofar as the firms in question are true comparables/operate within in the same industry and face the same exogenous pressures. But if this is all you're doing, then why do a DCF at all? Why not just look at profitability and PEG ratios?

he's looking for a few things:

basic understanding of current debt pricing current understanding of cost of equity calculations ie industry risk fundementals.

I would assume a 8%, all-in, senior debt cost of capital for energy, 9% for telecom and 10% for internet, for well established companies as the assets used to secure these assets gets smaller as the pricing goes up.

His main target in my opinion is your understanding of the Beta for each of those industries.

If you have good reason's why each industry has more debt vs equity good, if not stick with a 50/50.

At the end it comes down to the relative volatility of the industry in relation to the market with beta (from lowest to highest) energy, telecom, internet.

Generally speaking, this is how I would approach this question:

Internet Company: Lack of cash flows means no cash-flow/asset based lending, capital structure is going to be made up of predominantly equity which is going to be the most expensive. Use CAPM to calculate cost of equity and use that was your WACC (assuming no debt)...I am not getting into the CAPM calculation but its pretty straightforward.

Telecom Copmany: Has assets, and based on cash flow situation, for the mature companies like ATT and Verizon this is pretty strong so obviously there would be debt on the books so the WACC is going to be lower than that of the Internet Company.

Energy Company: I consider energy to be something that is going to be cut back on last by consumers, so essentially given constant demand (public utility company like Con-Ed), they've got more debt than equity since they can get it cheaper...so its going to be the lowest of the three.

Thats my take on it. Its a fun question in the sense that you can get really creative with it and im sure some other people on here will get creative and post responses.

Hello,

In both cases you need to use the target cost of capital. Many bankers get this wrong. You always value the target using its own risk profile characteristics. It's in the synergy calculation that benefits of scale, more favorable optimal capital structure, etc should be quantified and allocated to buyer and seller (the proportion of how much is allocated to buyer vs seller depends on whether the benefit the target brings are unique).

In the second example you describe, where the acquirer is contemplating only acquiring certain assets, i am assuming you are buying the assets free and clear of any debt, which is why you're pondering using the acquirer WACC, correct?

In this case, you would value those assets on a standalone basis using a WACC that equals the target's cost of equity (using an unlevered beta). The little caveat there is that if the assets being acquired have a very different risk/cash flow profile from the remaining assets, then taking the full company's beta is still not super accurate, but you are on much more defensible ground than using the acquirer's WACC.

In any case, you need to use the discount rate that captures the risks associated with the cash flows you are discounting.

In the first case the wacc should capture the risks associated with the target company.

In the second case you need to use a wacc that reflects the risk associated with the set of assets you are acquiring (probably using betas and debt to equity ratios of a set of companies that closely reflect a stand alone operation similar to the acquired assets).

^ Agreed. If a good comp set exists, this is a good approach.

Thank you! That is very helpful.

So the discount rate should always be constructed to mirror the profile of what is being acquired? I suppose it's easy when trying to acquire an entire company - since you can just calculate the WACC of the target, but what happens if you are acquiring a division of a conglomerate (such as GE?) The firm's overall WACC would not reflect the division's WACC. I suppose one way is to look at comparables and find the appropriate beta to formulate the cost of equity, but is there a better way? Also, for the cost of debt, would I just take a rough yield on the division's debt?

Thanks

What you try to do is to find comparable publicly traded companies that closely resemble the "division" you want to value. Since usually divisions focus on specific businesses, ideally you will try to find "pure players"....publicly traded companies that only have only one business (similar to the division u are trying to value). Now, this is easier to say than to do. Usually pure players are hard to find and you might have to settle with a set of companies that are close enough to your company (highly subjective).

For the debt I would suggest you to compare both the company's debt to the debt of the set of comps you selected for your beta calculations. If those two are similar you could go with either. If those to are far apart then u need to understand why there is a difference before you take your decision; but given that you are already using the comps for your beta you should probably use the same set to estimate the cost of debt, as this would better reflect a stand alone operation. Remember that divisions of large corporations might benefit from favorable terms just because of their parent companies, which might not be reflecting the risk associated with the division. Also, debt might be at the holding company level, which might give you a wrong indication of the correct debt to equity ratio.

Thanks!

bump