Discounting - a method
for determining present value. To
arrive at a present value of future money, we
need a method that accounts for why current dollars
are worth more than future dollars. The mechanism
for capturing these elements is the discount rate—the
rate at which future cash flows are discounted
back to today’s dollars. The discount rate
varies in a common-sense fashion:
- If receiving cash flows now is important,
the higher the discount rate.
- If the risk of not receiving future cash flows
is high, the higher the discount rate.
- If inflation is expected to rise, the higher
the discount rate.
A discount rate vastly simplifies the valuation
process—incorporating each of these three
elements (current consumption preference, risk,
and inflation) into a single, easily-applied metric.
For example, imagine you are a venture capitalist.
Entrepreneurs pitch business plans to you all
day, desperate for your investment dollars. Each
of the possible projects is very different: They
have different time horizons—some predict
it will be only one or two years before an expected
return on investment, others five or more years.They
all carry varying degrees of risk—perhaps
some are in established industries and markets,
while others look to delve into emerging areas.
There may even be different inflationary environments
to consider if you are working in international
How do you even begin to undertake what seems
like an “apples and oranges” comparison?
The answer is in the discounted cash flow methodology.
By applying a discount rate appropriate
to each potential investment, we bring these disparate
opportunities down to a single, comparable value.
After applying the DCF methods, we have a sense
of what the value of each of the projects is to
you, the investor, in present day dollars, not
future projections and promises. Once cash flows
are brought to the same point in time and assigned
a present value, meaningful comparisons and aggregations
can be made.
Who decides what discount rate to apply?How do
they decide? There are no firm answers to these
questions. These decisions rest on the grounds
of professional judgment. Suffice it to say, this
is where accountants, valuators, managers, and
lawyers really earn their paychecks.
We begin by first learning the fundamental mechanics
of present valuation.
Note on terminology
Before proceeding, an important
note on terminology: Often appraisers and business
people will use the terms discount rate
and interest rate interchangeably.
The discount rate is simply the converse of
the interest rate. When the present value is
known, an interest rate can be applied to project
forward to a future value. When the future value
is known (or, at least expected), a discount
rate is applied to project backward to today’s
Of course, lay people are more
familiar with the term interest rate, so it
is used sometimes even when the valuator is
discounting a future cash flow.