What is a discount rate?
A discount rate is a rate of return used to convert the future value of a financial asset to the present value.
This rate is related to the concept of the time value of money, which conveys the idea that money today is worth more than money tomorrow because it can earn a return if it is invested today.
The discount rate reflects the “price of money.”
If money is “expensive,” as expressed by high interest rates and a high equity risk premium, this will be reflected in a high discount rate for financial assets.
The opposite is true if money is “cheap.”
There is an inverse relationship between discount rates and present value. Keeping all else equal, the higher the rate, the lower the present value of an asset.
What’s in a Discount Rate
Discount rates are important for valuing financial assets because most investments reflect the present value of future cash flows.
These rates are also used to benchmark the relative attractiveness of fixed income investments.
Because different investments carry different risks, different rates must be applied, depending on the asset class and risk profile.
Rates and Risk
When evaluating low-risk investments such as short-term bonds or certificates of deposit (CDs), the most appropriate discount rate is the risk-free rate.
The risk-free rate is represented by US Treasury bonds, which convey the rate the government can borrow money at.
The risk-free rate reflects what investors are willing to earn on a risk-free investment. This rate takes into account general economic conditions such as the annual rate of inflation.
Corporate bonds are moderately more risky than short-term bond funds because they must account for a greater risk of default. Therefore, the discount rate of a corporate bond could be thought of as adding the risk-free rate to the risk of default.
The stock market carries greater risk than the bond market because stocks have no obligation to repay an investor’s principal. Investing in a stock is taking risk in an underlying business’s success.
The most widely used discount rate for stocks is the weighted average cost of capital (WACC), which takes into account a company’s cost of debt and equity capital.
Even within the same asset class, different securities have different risk profiles.
Larger companies perceived to be more stable require a lower discount rate than smaller companies with more volatile financial characteristics.
Investments denominated in foreign currencies require a higher discount rate to reflect currency fluctuations.
Also, investments made in emerging markets may require higher rates of discount to reflect political uncertainty. As the table below shows, these risks are cumulative.
This is all to say that there is a great deal of information embedded into a discount rate which reflects an asset’s underlying risks and characteristics.
The present value of a financial asset can be greatly influenced by small changes in these rates; therefore, determining the appropriate discount rate is worth careful consideration.