Concept Paper on Estimating Discount Rates in Valuation
Concept Paper on Estimating Discount Rates in Valuation
Introduction
Discount rate used in valuation reflects the riskiness of the asset and is one of the critical inputs
of Discounted Cash Flow method.
ICAI Valuation Standards 2018 defines “Discount Rate” as the return expected by a market participant from a particular investment and shall reflect not only the time value of money but also the risk inherent in the asset being valued as well as the risk inherent in achieving the future cash flows.
ICAI Valuation Standards recognise the following three approaches in valuation and they are globally accepted approaches as well: –
1) Market Approach
2) Income Approach
3) Cost Approach 
Income approach is considered as one of the most appropriate approach under-going concern as it determines the intrinsic value of an asset by estimating the present value of future earnings of assets. Income Approach is also not as vulnerable to accounting conventions (like depreciation, inventory valuation) in comparison with the other techniques/ approaches since it is based on cash flows rather than accounting profits.
The Income Approach includes a number of methods, such as Discounted Cash Flow (DCF) Method, Relief from Royalty (RFR) Method, Multi-Period Excess Earnings Method (MEEM), With and Without Method (WWM) and Option pricing models such as Black-Scholes-Merton formula or binomial (lattice) model.
Discounted Cash Flow Method (DCF) is the most commonly used method in valuation and it arrives at a value by projecting the cash flows in the future and then discounting the cash flows back to the date of the valuation using the Discount Rate.
While discount rate is an important factor in valuation but at the same time estimating discount rate is difficult and also prone to judgement. Therefore, understanding the methodology and concepts in determining an appropriate discount rate is extremely critical for valuers.
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