Lesson 1 of 5
What a discount rate is doing
A discount rate prices time and risk together. It cuts a distant cash flow far more than a near one, which is why the horizon matters most.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A discount rate turns a future dollar into what it is worth today, by pricing time and risk together.
- The same rate cuts a distant cash flow far more than a near one, so the horizon is what makes it matter.
- Valuing a whole business needs the company's blended cost of capital, not your own personal target return.
A discount rate answers one question: how much would you need to set aside today, at the same risk, to end up with a given cash flow on a future date. It prices two things at once. Most disagreements about a discount rate are really about only one of them.
What $100 arriving in ten years is worth today
- Discounted at 4%$67.56
- Discounted at 8%$46.32
- Discounted at 12%$32.20
Time and risk, added together
The first part is time. A certain cash flow arriving in five years is worth less than the same cash flow today, because the money could have been earning something in the meantime. This part is observable: it is close to the yield on a government bond of the same maturity.
The second part is risk. The cash flow is not certain, and you require compensation for that. Nothing states this part. It is the extra return you personally require to hold this business instead of the bond, and a discount rate is the two added together.
Why the horizon does most of the work
Compounding means the same rate removes more value the further out a cash flow sits. The figure above holds $100 fixed and only changes the rate; the same effect runs the other way, holding the rate fixed and changing how far out the cash arrives.
The company's rate, not your own
The standard rate for valuing a whole business is its weighted average cost of capital: what the company pays for its money, blended across equity and debt. Cash flows to the whole firm belong to everyone who financed it, so the rate is their blended requirement. Discount cash flows to the firm at the WACC and subtract net debt at the end. Discount cash flows to equity at the cost of equity and subtract nothing. Mixing the two is the common error. Your own hurdle rate is a separate test: compare the return the price implies with your alternatives.
Why nobody can hand you the number
Two people can compute a correct cost of capital for the same company on the same day and reach different rates, without either making an arithmetic error. They chose different equity risk premiums, or measured beta over a different window. Later lessons in this course take those two choices apart on their own. The useful habit is not finding a better source. It is computing a valuation at both ends of the range you would defend, and checking whether the conclusion survives the whole range.
Check yourself
What does a discount rate combine?
- Only inflation and taxes
- The risk-free rate and a risk premium
- The company's growth rate and its profit margin
Show the answer
Answer: B.
A rate prices time (the risk-free rate) and risk (the premium you require to hold this business instead of the bond) together.At a fixed discount rate, a $100 cash flow arriving further in the future is worth today:
- More
- Less
- The same
Show the answer
Answer: B.
Compounding works both ways. The same rate removes more value from a cash flow that arrives later, which is why a distant terminal value is the most rate-sensitive part of a valuation.Which rate should discount cash flows available to both debt and equity holders?
- Your own personal target return
- The company's cost of equity alone
- The company's weighted average cost of capital
Show the answer
Answer: C.
Cash flows to the whole firm belong to everyone who financed it, so the rate has to be their blended requirement, not one investor's hurdle or the equity cost alone.Sources
- Williams, The Theory of Investment Value, 1938: value is the present value of the cash an asset distributes.
- Damodaran, Investment Valuation and The Dark Side of Valuation: the standard treatment of a discount rate as time plus risk, and of terminal value sensitivity.
What this leaves out
- This lesson is about the reasoning, not a number. It does not suggest a discount rate to use.
- It describes the standard treatment for a going concern with ordinary financing. Financial companies, businesses funded in several currencies and anything close to distress usually need a different tool.
- Nothing here is advice about any security.