Building a discount rate, component by component

The discount rate is where a valuation is won or lost quietly. Move it three points and the value swings by double digits, yet many reports present the rate as a single unexplained number. The build-up method fixes that: the rate is assembled from components, each with a source, so a reviewer can argue with the pieces instead of guessing at the whole.

The structure

A build-up rate stacks four layers. Each answers one question: what does a dollar earn with no risk, what does public equity add, what does small size add, and what does this particular company add? The sum is the required return on equity for this business — the discount rate for its cash flows.

Layer 1: The risk-free rate

Start with the yield on the 20-year U.S. Treasury as of the valuation date. It is observable, dated, and undisputed, which is exactly what you want at the base of the stack. Use the long bond rather than a T-bill because the business's cash flows are long-lived; matching horizons is the point. This is the only component you can look up rather than support, so look it up and cite the date.

Layer 2: The equity risk premium

The equity risk premium is what investors have historically demanded for holding stocks over Treasuries — the price of bearing market risk at all. Published estimates cluster in the 4 to 7 percent range depending on the measurement period and method, and the honest move is to pick a published figure, name its source, and use it consistently across engagements rather than tuning it per job.

Layer 3: The size premium

Small companies have historically returned more than large ones, because they fail more often and their earnings swing harder. The premium measured on the smallest public companies adds several points, and a private company far below public-market size sits beyond the data the studies measure. This is the same size effect you can see from the other direction in transaction multiples: main-street businesses trade near 2.58 times SDE while lower-middle-market companies bring 4 to 6 times EBITDA. A high required return and a low multiple are the same fact stated twice.

Layer 4: Company-specific risk

The first three layers describe an average small company. The last one describes yours, and it is the only component that is pure judgment. It covers what the statistics cannot see: one customer at 35 percent of revenue, an owner who holds every key relationship, a lease with four years left, a competitor breaking ground across town. Depending on those facts this layer commonly runs from a point or two to well past ten for a genuinely fragile business.

Because it is judgment, it must be itemized. "Company-specific risk: 6%" convinces no one. Three points for customer concentration, two for owner dependence, one for supplier exposure — each with a sentence — turns the softest component into the best-documented one. This is where the analysis of the business meets the arithmetic, and it draws on the same facts as the seven value drivers.

Sanity check the total

Stack the layers and small private companies routinely land at 20 to 40 percent required returns. If your build-up produces 12 percent for an owner-dependent business with customer concentration, a layer is missing. If it produces 50, you have probably double-counted a risk that also lives in your cash flow forecast.

From discount rate to capitalization rate

The discount rate applies to a forecast, as in adiscounted cash flow. To capitalize a single stabilized year instead, subtract the long-term sustainable growth rate: a 39 percent discount rate less 5.5 percent growth gives a 33.5 percent capitalization rate. Keep growth modest — as it approaches the discount rate, the math drives value toward infinity, which is the formula's way of saying the assumption is wrong. ExitSight's build-up worksheet shows every layer, and the completed stack prints line by line in the report.