A discount rate or capitalization rate is used to determine the present value of the expected returns of a business. The discount rate and capitalization rate are closely related to each other, but distinguishable. Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.
 
In DCF valuations, the discount rate, often an estimate of the cost of capital for the business, is used to calculate the net present value of a series of projected cash flows. The discount rate can also be viewed as the required rate of return the investors expect to receive from the business enterprise, given the level of risk they undertake. On the other hand, a capitalization rate is applied in methods of business valuation that are based on business data for a single period of time. For example, in real estate valuations for properties that generate cash flows, a capitalization rate may be applied to the net operating income (N01) (i.e., income before depreciation and interest expenses) of the property for the trailing twelve months.
There are several different methods of determining the appropriate discount rates. The discount rate is composed of two elements: (1) the risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, such as a high quality government bond; plus (2) a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate.
Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied. Capitalization and discounting valuation calculations become mathematically equivalent under the assumption that the business income grows at a constant rate. Capital Asset Pricing Model (CAPM) The capital asset pricing model (CAPM) provides one method of determining a discount rate in business valuation. The CAPMoriginated from the Nobel Prize-winning studies of Harry Markowitz, James Tobin, and William Sharpe.
The method derives the discount rate by adding risk premium to the risk-free rate. The risk premium is derived by multiplying the equity risk premium with "beta", a measure of stock price volatility. Beta is compiled by various researchers for particular industries and companies, and measures systematic risks of investment.
CAPITALIZATION-RATES