As discussed earlier, the discount rate is used to establish an expected return on investment and is primarily driven by the riskiness of the future earnings. Not likely that the website will survive? A higher discount rate must be applied. Is the site well establish and have variety of well-diversified income streams? This will call for a comparatively lower discount rate.

The discount rate is established from a finance basic called the Capital Asset Pricing Model and is based off the following components: a risk free rate, a market risk premium, and a beta. I will define and describe each next but basically the model says that the expected return on an investment should equal the expected return on a risk free investment plus some risk premium. The higher the risk, the higher the premium. Before describing the components it should be noted that detail studies, research, and examples can be found commonly on the web by doing a search on the given term.

Risk free rate: The risk free rate is the return that can be expected by investing in something that is commonly considered to be risk free. A good example here is government bonds or treasury bills. The returns on treasury bills are low, but you know you are going to get that return (currently in the low single digits). If there were some uncertainty around getting the expected return, an investor would demand a higher rate. Another example here is the common bank savings account or certificate of deposit.

Market Risk Premium: The market risk premium is the amount above the risk free rate that is associated with the risk that you may not get the expected return. The stock market is a good example here. Historically, the stock market has given investors a return of 7% - 8% ABOVE the theoretical risk free rate given on Treasury Bills. This is because the investor may get the return or they may not. If the risk free rate on Treasury Bills is 3%, the return on the stock market would be about 10%-11% historically speaking. However, one year it may be 22%, the next it could be 2%. This is the risk-reward relationship.

Beta: The beta is a more complex topic so I will try to simplify it here as best as possible. First, it is important to understand two different types of risk: market-wide risk vs. company or project-specific risk. When we talked about the Market Risk Premium above, we were only speaking about risk associated with the entire market (i.e. the stock market). If the whole market drops, chances are your stocks will drop. On the other hand, there is risk associated with a specific company, website, or project that may be more or less than market risk. The beta is a number that when multiplied by the market risk premium gives you a risk premium specific to your website, project, or company. A beta of 1 means that your specific risk moves with that of the market. For example, when the market return (as we learned earlier is based on future profits) falls by 3%, your company or project also falls by 3% (beta = 1, specific risk = 3%*1 = 3%). If your specific company or project is riskier than the market, it may have a beta of 1.5 (beta = 1.5, specific risk = 3%*1.5 = 4.5%). This goes along with what we learned earlier, the higher the risk, the higher the return.

Mathematically, the beta is derived using statistics to correlate the historical returns of the project with the market. Getting into those details is beyond the scope of this book. The yahoo financial site is a good place to see the beta in action. You would expect to see the beta of a web-based business to be higher than say, a utility business. As of the time of this writing, the beta of Ameritrade (ticker: AMTD) is 2.86 and the beta of utility Dominion Resources (ticker: D) is .295. To see this, look up the company ticker at Yahoo and choose "Key Statistics" from the Company menu.

Now that we have the market risk premium we can look at the model in action. There is a dedicated page on the spreadsheets that came with this book that will take into consideration specific website risks and calculate a fair discount rate for the valuation. The model for the discount rate is:

risk free rate + beta*(market risk premium)

*quick example: Let’s assume that the risk free rate is 3% and the market risk premium is 7.5%. The expected return on Ameritrade stock would be:

3% + 2.86*(7.5%) = 24.45%

Note: The explanations and additional comments for each component are included with the spreadsheet so you don’t have to worry about coming back here to refresh your memory.

Home