- How The Discount Rate Works
- Discount Rate vs. Interest Rate
- How To Calculate The Discount Rate
- Cost Of Capital vs. Discount Rate
- How the Rate Of Discount is Used
- Example: Calculating Present Value Based using a Discount Rate
- Importance of a Discount Rate for Investors
- Discount Rate Assumptions & Limitations
- Uneconomical Projects
- Bottom Line
A discount rate is a percentage rate that investors use to measure the value of future cash flows in today's dollars. A discount rate has a wide variety of applications in terms of analyzing opportunity cost, calculating expected rates of return, and quantifying risk.
How The Discount Rate Works
Broadly speaking, a discount rate is a rate (denoted in annual % terms) that investors or management teams use to measure the value of future cashflows. Receiving $1 million today is favourable to receiving $1 million in 15 years from now; future cash is worth less than its face value in present value terms. A discount rate can be applied to future cashflows to determine how much they are worth today.
Companies will look at the future expected cash flows that a project will generate and then discount them by a set interest rate or required rate of return to see what the value of the project is in today's dollars. If a project has a positive expected value after accounting for the time value of money at a given discount rate, management may be encouraged to proceed with the investment.
Higher vs. Lower Discount Rate
A high discount rate results in future cashflows being valued at less than if a lower discount rate was used. Higher discount rates can reflect higher interest rates, higher inflation, a higher level of risk associated with receiving a future cashflow, or a combination of these or other reasons.
A higher discount rate requires a higher expected cash return for it to be deemed a profitable venture. A lower discount rate, by contrast, makes it somewhat easier to conclude that an investment or project is worth pursuing.
Discount Rate vs. Interest Rate
A discount rate is similar to an interest rate, and its % value is usually a related to current interest rate levels. In almost all cases appropriate discount rates are higher than interest rates.
For example, imagine a company with $10 million in the bank is considering spending this money on a project that is expected to be worth $11 million in 5 years from now. This may seem like a great idea given the $1 million expected profit. But that return is only about 2% per year. If the bank was paying the company a 3% interest rate (annually), they would actually earn a better return by not pursuing the project. So this company would use a discount rate higher than 3% in assessing the appeal of new projects.
The discount rate is one specific to a particular investor or company's situation. A company typically chooses its discount rate or hurdle rate for new investments based on current interest rates plus a risk premium specific to the potential investment opportunity which is under consideration.
If, in the above example, the company could earn an annual return of 3.1% on the new project, would they pursue the project? Likely not, since it usually wouldn't be worth the effort and risk to take on this project for only an extra 0.1% above the interest rate the bank was paying.
Key Takeaway: There is no singular universal discount rate applied to all future cashflows. Different companies and investors will apply different discount rates in different circumstances.
How To Calculate The Discount Rate
There is no one discount rate that universally applies. Some companies may use a discount rate equal to what's called a hurdle rate for their company. Others may base a discount rate on their cost of equity, cost of debt, weighted average cost of capital (WACC) or other such metrics. Here are a few examples.
The weighted average cost of capital, or WACC, is a commonly-used formula for determining the rate at which a company has to pay to access funds.
It is calculated, most simply, by blending the cost of a company's debt and equity. The blend is based on the company's capital structure. If a company has 40% debt and 60% equity, for example, then the equity cost of capital would represent 40% the cost of debt and 60% the cost of equity.
If a company has issued preferred stock, it is included along with the equity and debt components of the blend as well.
Also, the interest on debt is often discounted by the corporate tax rate if that interest is tax-deductible.
2. Opportunity Cost
Another way to think about discount rates is in terms of what a company foregoes to make a certain investment. If it builds a new factory, for example, that capital can't be used to expand its warehouses, open a distribution center in a new market, or upgrade machinery at existing plants. Every decision must be considered not just in absolute return on investment terms but also what other possibilities the company is giving up to choose this particular route.
Those opportunity costs aren't just in the operations side of the business. Instead of investing in new capital expenditures, a company could also choose to pay down debt or buy back stock with that same capital.
For example, if a company has callable debt outstanding that pays 8% interest, it wouldn't usually make sense for the company to pursue a new project that pays a 4% return. It would make more financial sense to pay off the debt to lessen its interest burden.
On the equity side, if a company is trading at, say, 12.5x times earnings, that represents an 8% annual earnings yield. That 8% available return on potential stock repurchases serves as a sort of benchmark against which to compare other opportunities.
3. Adjusted Present Value
Another popular way of determining a discount rate is through adjusted present value (APV). Adjusted present value starts with the net present value (NPV) of a transaction and adds in the additional present value of the impact of financing on a transaction. In doing so, this incorporates the equity cost of capital and potential tax benefits from tax deductibility on interest. However, APV often tends to be used in academic settings for analyzing transactions rather than being used by the businesses making deals themselves.
Cost Of Capital vs. Discount Rate
The cost of capital and the discount rate may seem like two sides of the same coin. However, there is a subtle difference between the two concepts.
- The cost of capital is how much a company has to spend to obtain funding and thus serves as a hurdle rate for future investments.
- The discount rate, by contrast, is how much companies or investors discount cash flows from future years to reflect the present value of those eventual profits.
How the Rate Of Discount is Used
A discount rate can be used for a variety of reasons, including:
- As a hurdle rate to guide management toward whether an investment opportunity is potentially viable or not.
- To calculate a business' net present value. Particularly for long-life assets such as royalty streams, it's valuable to get an accurate handle on how much value distant years of future cash flow are worth in today's terms.
- As part of discounted cash flow ((DCF)) models and analysis.
Example: Calculating Present Value Based using a Discount Rate
The formula for calculating Present Value using a discount rate is:
Present Value = Future Cashflow Amount / (1 + discount rate)t
where t = the number of years
For example, how much would a cashflow of $10,000 be worth today if it's received in 7 years from now, at a discount rate of 8%?
Present Value = $10,000 / (1.08)7
Importance of a Discount Rate for Investors
It's helpful to think of an example. Let's take $100. At a 10% discount rate, $100 five years from now is worth about $62 today:
At a 4% discount rate, that same $100 of future capital would be worth about $82 today.
If a firm is investing $65 today expecting to receive back $100 in five years, the discount rate helps frame the investment decision. In a riskier world with a 10% discount rate, the firm should forego the potential investment as it would be putting it $65 to get back just $62 of fully discounted value. In a world with low discount rates, however, this investment would make sense, as that $65 would now turn into $82 of fully discounted value.
Interest Rates & Inflation
There are many things that go into a discount rate. However, interest rates and inflation are the most obvious duo, and the above example shows why. If inflation expectations are high, firms must earn much higher returns on capital to generate shareholder value. The value of money in the future is highly dependent on the inflation rate and risk-free interest rate between now and that future date.
In recent years, in the world of persistently low interest rates, investors and management teams set lower and lower discount rates. However, with both interest rates and inflation surging, discount rates are moving up as well. This will cause many projects which were previously assessed as profitable to no longer generate a positive economic return. For example, developing a gold mine that requires $50m of borrowing might have appeared profitable when interest rates were at 1%, but not so much at 5% interest rates.
Discount Rate Assumptions & Limitations
There are a couple of important things to consider with the discount rate.
1. They Can Give a Sense of a False Precision
Critics say that discounted cash flow models can lead investors into trouble because it gives a sense of a false precision. In the real world, however, revenue flows and operating costs can be very volatile. A project requiring substantial manpower may look substantially less profitable in the case of rising wages, or the project could suffer from costly delays due to a labour shortage.
2. Instability of Interest Rates
Interest rates are also variable, of course. From 2009-onward, it seemed that companies could rely on interest rates and inflation remaining low and thus set more aggressive discount rates. Over time, many people's discount rates crept down from the double digits to well under 10% in certain uses. After the sharp interest rate increases of 2022, however, those discount rates / hurdle rates likely had to be adjusted back up, which lowers projected returns on many investments.
These are not necessarily flaws with the discount rate framework itself, but rather in its use. As with any financial model, investors should be aware of potential biases in their data inputs and consider using the discount rate analysis as part of a broader set of variables when looking at a potential investment opportunity.
Both companies and investors alike could potentially benefit from modelling multiple scenarios for projects, such as an optimistic case and a pessimistic case.
Although it contradicts conventional finance, some companies knowingly proceed with projects that they don't expect to generate profitable returns on a discounted cashflow basis. Such projects may be pursued for reasons other than predictable economic returns, such as building a moat, preventing a competitor from gaining a foothold in the industry, reputational benefits, or other reasons.
Investors, on the other hand, are more likely to avoid cash outlays that do not generate a sufficient risk-adjusted discounted cash flow return.
Discount rates are a key concept that lies at the foundation of financial management. Companies and investors use discount rates for a variety of purposes including modeling the value of an asset and judging whether a potential use of capital will generate a sufficient return on investment. Discount rates are applied to future cash flows to determine Net Present Value.
This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.
Ian leads the investing group Ian's Insider Corner. Features of the group include: the Weekend Digest which covers everything from new ideas to updates on current holdings and macro analysis, trade alerts, an active chat room, and direct access to Ian. Learn More.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.