Chapter 12
Required rate of return

In Chapter 11, we examined the first element of a valuation, the benefit stream. The next step is to divide the benefit stream – in this example, cash flow – by the required rate of return, or capitalization rate.

Again, here is our hypothetical valuation of a 5 percent interest in a midsize trucking company:

The required rate of return is the return on investment you expect based on the risk you assume. Perhaps you have heard trucking owners talking about the multiple of EBITDA at which their company sold. Or you might hear analysts mention the price-to-earnings ratio that a public trucking company is trading on the stock exchange. The capitalization rate is the inverse of this multiple or ratio. For example, if the multiple is 4, then the capitalization rate is one divided by the multiple – one-fourth, or 25 percent.

The build-up method
One of the most common methods for determining the capitalization rate is the build-up method. This method assumes that you could invest your money in other avenues while assuming smaller risks and get the returns you expect.

The build-up method starts with the least risky investment (the “risk-free” rate) and builds up to the risk associated with an investment in the subject company. The rate determined is officially known as the discount rate. A capitalization rate is derived from a discount rate by subtracting an estimated long-term growth rate.

The calculation begins with a “risk-free” rate of return and adds the rates of return on publicly traded stocks and the relative risks associated with the stock of the subject company relative to the overall stock market. The least risky investment available, most think, is the United States Treasury’s Long-term (20-year) Coupon Bond. At December 31, 2004, the rate of return for this investment was 4.85 percent. This is known as the “risk-free” rate. An investor could expect an investment in this Coupon Bond to yield a 4.85 percent return on his investment with virtually no risk. So if your trucking company is only returning 4.85 percent or less on your equity, then you should consider exiting the trucking industry and investing in a treasury bond.

Market risk. The next two components of the build-up method consider market risk or in general, the risk of doing business. The first of these rates of return is known as the equity risk premium. This rate of return is the additional return that an investor would require over the “risk-free” rate from investing in sizeable equity securities on the S&P 500 from 1926 to the period covered in the business valuation. This rate focuses on the long-term because long-term historical returns have been stable. The equity risk premium at December 31, 2004 was 7.2 percent.

The second component to consider in the market risk is the small stock premium. The small stock premium is the additional return that an investor expects over the large equity securities. This additional return is achieved by investments in smaller equity securities. The small stock premium was 6.34 percent at December 31, 2004.

Company-specific risk. The final element of the build-up method is the company-specific risk premium. This rate considers an investment in the subject company’s stock relative to the stock market as a whole.

Company-specific risk can be determined using several available methods. For example, the Finison/Dailey Model quantifies the company-specific risk by using a SWOT analysis, which examines the strengths, weaknesses, opportunities and threats of a business. Strengths and weaknesses are internal factors of the business while opportunities and threats are external to the business.

The Finison/Dailey Model assesses company-specific risk by gauging the risk of internal factors such as strategy, mission and vision, organization, marketing, innovation and growth, products, operations and finances based on a five-point scale. For example, one specific factor analyzed within the organization category is whether a succession plan is in place. If a plan is in place, it will rate this as positive on the five-point scale, which lowers the company-specific risk. However, if a succession plan is not in place, a negative rating will be given and the company specific risk will increase, thus saying the company is more risky.

The same process is followed in the analysis of opportunities and threats, but the subject company will be compared to similar companies in the industry to weigh the risk. Healthy trucking companies will rate from 3 to 6 percent in the company-specific risk area.

The rates determined by these methods undergo further adjustments before the appropriate capitalization rate is determined. One change is a tax conversion. The benefit stream and the capitalization rate must both be either pretax or after tax. Often a pretax benefit stream is used to value a company. In those cases, the capitalization rate must be converted to a pretax capitalization rate by dividing the capitalization rate by the sum of 1 minus the tax rate. The after-tax capitalization rate is then subtracted from the pretax rate and the resulting number is the adjustment.

Below is a visual representation of the build-up method, illustrating how each component is added into the model based on the percentages provided in the discussion above.

Build-Up Method

Cash flow vs. earnings multiples
Multiples are important, but even more important are the benefit streams to which the multiples refer. Some of the more common are multiples of EBITDA and price-to-earnings multiples. A multiple of EBITDA is considered a cash flow multiple because it adds back non-cash expenses such as depreciation and amortization.

A multiple of EBITDA indicates the price at which a company was sold by providing a number times EBITDA. For example, if similar companies are selling at a multiple of EBITDA of 4.0 and the EBITDA of your company is $1 million, then you should expect approximately $4 million from the sale of your business less any discounts discussed in the next chapter. To look at it another way, an investor would pay you $4 million for an anticipated annual cash flow of $1 million.

The price-to-earnings multiple is an earnings multiple. A price-to-earnings multiple of 3.0 would represent a price of 3 times the earnings of the company. Earnings would include depreciation and amortization expenses. Using our previous example of an EBITDA of $1 million, and assuming that depreciation and amortization expenses total $250,000, our earnings before interest and taxes (EBIT) would be $750,000. Then we would multiply the price-to-earnings multiple of 3.0 by the EBIT of $750,000 to arrive at our approximate price of $2.25 million.

Other methods
Other methods for determining the capitalization rate (or discount rate) include the Capital Asset Pricing Model (CAPM) and the Weighted Average Cost of Capital (WACC). The Capital Asset Pricing Model is very similar to the build-up method, but factors in beta, which is a measure of stock volatility as computed on the major stock markets. Therefore, CAPM considers the risk of large and small equity securities but also considers the volatility of these stocks.

The Weighted Average Cost of Capital accounts for the risk of your company based on the equity and debt blend in the company. The attempt here is to establish what the company anticipates to pay out to bondholders and shareholders for each dollar of capital that the company raises for them. It also splits out the overall risk with that associated with debt and that associated with equity. We all know that a trucking company loaded with debt is more risky than a trucking company with low debt.

The next chapter rounds out the valuation in a nutshell by analyzing appropriate discounts to the final value.