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.T
The discount rate is used in the Discounted Cash Flow valuation method. 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 discount rate is applied against future expected cash flows for multiple years. The capitalisation rate is only applied to 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 continual in perpetuity at the same level.
The key difference is that in under the DCF projections, growth is built in to the expected earnings (not the discount rate). Under the FME model, growth (providing it is minimal) is built in to the capitalisation rate.
About the Author
Simon is CA Accredited Business Valuer, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the giant Bernie Madoff Ponzi scheme. Simon provides valuation services in disputes, to raise finance, to assist in transactions, for tax purposes and for restructuring.
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