In the world of valuation, damages, and lost profits (oh my!), one pesky topic that resurfaces is discount rate.
In my role as an instructor at the local university, I spent the last couple weeks honing in on present value and discount rates with this semester’s group of students. I have said it before, and I will say it again, I learn so much in this instructing role! As a class, we discussed and considered many interpretations of what a discount rate was, and how it should be applied and interpreted.
To start, let’s review how a discount rate works. Assume we are evaluating an investment that we estimate will yield $100,000 in annual benefit for the next 5 years. Simple math will tell us that this investment is worth $500,000 in total.
However, our simple math neglects to account for an appropriate return on investment required to compensate for the risk and uncertainty of the investment.
Now enters, the discount rate. The discount rate helps us estimate the risks and uncertainties attached to a particular investment.
Let’s assign a discount rate of 20 percent to our example and see how this affects the investment value in today’s dollars.
| Year 1 | $83,333.33 |
| Year 2 | $69,444.44 |
| Year 3 | $57,870.37 |
| Year 4 | $48,225.31 |
| Year 5 | $40,187.76 |
| Value of investment today | $299,061.21 |
The Year 1 expected benefit is worth more to us today than the Year 5 expected benefit. The higher the discount rate, the steeper the decline.
For instance, let’s see what a 40 percent discount rate looks like.
| Year 1 | $71,428.57 |
| Year 2 | $51,020.41 |
| Year 3 | $36,443.15 |
| Year 4 | $26,030.82 |
| Year 5 | $18,593.44 |
| Value of investment today | $203,516.39 |
The discount rate that we use in evaluating a particular investment makes a huge difference in the estimate of value.
So how do we choose an appropriate discount rate? And what exactly is (and what is not) a discount rate anyway?
Discount rate vs. current market interest rate
There are a countless number of market interest rates published for analysis. These measures might include a risk-free rate earned on government bonds, savings account interest earned at the bank, and an average expected return on various mutual funds.
These market rates of interest provide guidance of market conditions, but they do not take into account the risk and uncertainty specific to a particular investment.
The risk-free government rate does not factor in any risk that the investment will not yield the expected amount in the future. An average expected return for a mutual fund would assume a balanced portfolio of numerous investments where various risks are diversified and mitigated across the portfolio.
These scenarios are quite different than, let’s say, an interest in a privately-held company. In evaluating a particular investment, a measure of current market conditions is important, but only represents one piece of the puzzle.
Discount rate vs. financing rate
In some situations, an investor might finance an investment with a loan. Is the financing rate to be charged by the lender an appropriate proxy for the discount rate used when evaluating the investment itself?
In short, no.
The rate charged by the lender measures the risk to lender over the life of the loan. Length of the loan, available collateral, credit history of the borrower, and competitive pressure from other lenders would all be incorporated into the financing rate.
A discount rate used to value a particular investment, estimates the risk and uncertainty attached to that specific investment, over the life of that investment.
An appropriate discount rate
Let’s assume we are evaluating an interest in a privately-held company. To make it more tangible, we will assume the numbers in the original example. We expect our investment will reap $100,000 in annual benefit over the next 5 years. At this point, we know that the investment is worth less than $500,000 in today’s dollars. But how do we determine an appropriate discount rate?
#1: Revisit the forecast of annual benefit.
How true are our forecast numbers? Is the forecast too aggressive or maybe too conservative? Does the forecast dial in to our expected cash flow? Or are there are there some “soft numbers” rolled in? Are we confident in the growth (or lack of growth) factored in to the forecast? Any effort we place on establishing an appropriate discount rate is lost if our forecast of annual benefit is inaccurate. Furthermore, studying the forecast will likely reveal a few risk factors that we can incorporate into #2, below.
#2: Perform a comprehensive study of risk.
A base interest rate is easy to come by, as discussed above, in “Discount rate vs. current market interest rate.” The tricky part is assigning the risk specific to the particular investment. In our example, we are valuing an interest in a privately-held company. Below are a few brainstorming questions to get us started.
A. What industry does the potential investment operate within? What industry data is available?
B. How much history do we have on this investment? Does the history show a positive, negative, or no correlation to general market conditions?
C. Is this investment dependent on any major customers, suppliers, managers, location, or other key factors that may be subject to change?
We can see already that a 5 minute Google search is not going to save us on this one.
So, again I ask, what is a discount rate anyway?
A discount rate is a tool used to measure and account for an appropriate return on investment that will be required to compensate for the risk and uncertainty of the investment.
If an investment is assessed as high risk, the average investor will demand a higher return, a higher discount rate is used, and the value of the investment in today’s dollars will be lower. If an investment is assessed as low risk, the average investor will be satisfied with a lower return, a lower discount rate is used, and the value of the investment in today’s dollars will be higher.
In order to choose an appropriate discount rate, great care and consideration must be taken in evaluating an investment’s forecast of future benefits, as well as, all the risk factors specific to that investment.