Performing any sort of multi-year analysis requires you to establish a discount rate for cash flows, which is typically the Weighted Average Cost of Capital (WACC) for a company. The WACC is the combination of debt and equity costs, weighted by the amount of financing from each source.
When determining the debt and equity costs, the debt is typically a lot easier than the equity rate. If the company has debt, it also has an average interest rate on all of that debt, which becomes the cost of debt.
The Cost of Equity
The equity rate is a bit more difficult to determine, and certainly a bit more subjective. There are a few ways to establish a cost of equity though, and their simplicity adds a level of comfort.
What does the “cost of equity” mean, really?
First, it’s important to understand what the “cost of equity” really means. Let’s start with what the “cost of debt” really means, then translate it to equity.
The cost of debt is the interest rate of that debt. Fundamentally, someone gives you a large sum of money that you don’t currently have. Whoever gives you that money realizes that there is a chance you might not be able to make a payment or might not generate the return they hoped for. Now if you’re a huge, stable, publicly traded company, that risk can get pretty small. But you’re a small business with, say a few hundred thousand dollars in sales each year. There is an increased risk over that of a large company with $5 billion in annual sales. Therefore, your small business will pay a higher interest rate because you are riskier.
Now translating that to equity, it’s the same principle – a measure of risk. But how do you measure the cost of that risk?
Let’s start with something that, in theory, has no risk. A risk-free asset is commonly considered to be a Treasury bond from the US Government. The 10-year bond is the most commonly referenced. Just because it is considered risk free doesn’t mean that it has a return of 0% though. Over the past 20 years, the rate of return has fluctuated between roughly 2% and 6%. That risk-free rate will be the baseline.
From there, you have to add on additional risk that comes with your company. Additional risk doesn’t mean an investor is looking at your company and thinking that it is going bankrupt soon, though. From the investor’s point of view, it is a comparison between multiple investment options. Your company is not as large or as stable as the US Government’s source of funds so the investor will demand a higher rate of return if they invest in your company.
Method One - Capital Asset Pricing Model
For example purposes, let’s say your small business is actually quite large and can easily be compared to a publicly traded company. This is where the Capital Asset Pricing Model (CAPM) comes in (but it can be applied to small businesses as well).
CAPM is a model that essentially compares the risk of an asset to the risk-free rate and establishes a required return for the asset (usually a stock).
ERi = Rf + β(ERm - Rf)
ERi = Expected Return of your Investment
Rf = Risk Free Rate of Return
β = Beta of a potential investment
ERm = Expected Return of the Market
The big piece here is the Beta. It’s a number that measures the amount of risk versus the stock market, where 1.0 would mean it is theoretically as risky as the stock market.
In this example though, you are still a large private company which means you don’t have a Beta that is correlated with the stock market. However, there are likely other companies in your industry that are publicly traded so you look at them and get an approximate Beta for your company.
Now back as a small business. Using CAPM gets a bit more subjective, but still doable. You can still look at public Beta’s, but instead of saying you are very similar to them, you can say you have a similar model and in the same industry but you’ll have to increase the Beta a bit more due to the size of your company.
CAPM for small business – reference public company beta’s and increase the risk to reflect the size of your small business.
Method Two - Build Up Discount Rate
The other commonly accepted method is the Build Up Discount Rate method which, not surprisingly, starts off with the risk-free rate and “builds up” the additional risk associated with your company.
Cost of Equity = Risk Free Return + Market Return + Company Size premium + Industry Premium + Company Specific Premium
All factors are expressed at percentages
You can think of it as being riskier than the risk free rate and the stock market in total, and then you are “charged” a premium due to your company size, industry you’re in, and anything in particular about your company that would require a higher rate of return.
This works for both large and small businesses as the formula stays the same, but the numbers will change in magnitude.
If you think about it from an investor’s perspective, again, they would say that they can get a definite return from a Treasury Bond. Then they could invest in the stock market instead, but since it’s a bit riskier, they would expect a higher return. Investing in an individual public company would pose additional risk and therefore a slightly higher return, again. So on and so on until a reasonable rate of return is established for the amount of risk associated with your company.
Build Up Discount Rate for small business - start with the risk-free return and then add onto it to reflect the additional level of risk associated with your company.
It’s all a measure of risk
Determining the cost of equity will always be a bit more subjective than the cost of debt, but using these generally accepted methods, you can establish a pretty reasonable rate that you can then use in your discounted cash flow analysis and in your weighted average cost of capital.
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