The Market’s Effect on Discount Rates

When valuing a business under the income method, a discount rate is used to discount future cash flows to present value.  This discount rate, also known as the cost of capital, represents the expected rate of return available in the market from other investments that are comparable in terms of risk and other investment characteristics, and must be empirically supported by the practitioner.

One of the established methods for estimating the cost of equity capital is the Capital Asset Pricing Model (“CAPM”) in which the risk-free rate is increased by a risk premium proportionate to the systematic risk of the stock.  Under CAPM, systematic risk is measured by beta, a factor representing the sensitivity of the subject investment’s return to movements in the return on the market as a whole.  Although a forward-looking measure, beta is often estimated by calculating the historical relationship observed between the return on an individual security and the return on the market as measured by a broad market index such as the Standard & Poor’s 500 Stock Composite Index.  However, turbulence in the market can create problems with the traditional methods valuation professionals employ for estimating beta.

We urge extra care in the evaluation of CAPM calculations using recent data.  We would be glad to discuss more specifically how to address this potential problem.