Confusing a Discount Rate with a Cap Rate Will Result in an Inaccurate Value

Sometimes when I talk with business buyers and sellers (and sometimes even CPAs) they will use the terms “discount rate” and “capitalization rate” interchangeably.  While there is a definite direct correlation between a discount rate and a capitalization rate, they are not interchangeable, and will produce dramatically different values.  For example, if you are utilizing a capitalized earnings approach to value on a business that is projected to have $500,000 of free cash flow in the coming year and the correct capitalization rate for that business’ risk factors and growth rate is 25% then you will arrive at a value of $2 million.  However, if that same business’ appropriate discount rate is 29% and when using the capitalized earnings approach to value you utilize the discount rate instead of the capitalization rate you would arrive at an incorrect value of $1,724,138.  So what is the difference between the two rates and the relationship between them?  A capitalization rate is calculated by subtracting an estimated long-term constant rate of future growth from an appropriate discount rate.  So, if the appropriate discount rate for a particular business is 27%, and its estimated long-term growth rate is 4.5%, then the capitalization rate would be 22.5%.   So remember, when you are using a capitalized earnings approach to value make sure to use a capitalization rate not a discount rate, and when using a discounted cash flow approach to value use a discount rate, but don’t use them interchangeably.