The calculation of the cost of capital is usually done using the capital asset pricing model, or CAPM. The formula for the cost of shares is the risk-free rate of return plus the share price beta multiplied by the market rate of return (minus the risk-free rate of return). Typically, the 10-year Treasury bond (trading at 1.55% at the time of writing) is used as a risk-free rate of return and the market rate of return is usually the long-term average annual return for the stock market. Depending on the time series and market index you choose, you'll typically get around 9% (up to 12%) as the market rate of return. When it comes to determining what discount rate should be used for a discounted cash flow (DCF) analysis, there is no one-size-fits-all answer.
I prefer to use 10%, since it's roughly halfway through the various long-term market averages. Following our capital accumulation example in Figure 1, adding a size premium of 5.0% and a specific company of 4.0% to a stock market return of 7.75% leads to a discount rate of 16.75%. For a smaller, higher-risk company, this could be higher; however, for a larger, less risky company with a consistent history of solid profits, this could be lower. A stock discount rate range of 12% to 20%, more or less, is likely to be considered reasonable in a business valuation. This is in line with the anticipated long-term returns quoted to private equity investors, which makes sense, because a business valuation is a share in the capital of a private company.
Most investors use a discount rate between 7.5% and 9.5%. However, if you search the web for the best discount rates for businesses, you will find that the answers vary. In general, discount rates typically range from 6% to 20%. Massive multinational companies, such as Netflix and Amazon, with more than $1 billion in revenue, typically have a discount rate of between 10% and 15%. However, private companies in their early stages usually have a discount rate of more than 30% or even more.
Since a dollar a year from now is worth less than a dollar today, future cash flows are discounted at a discount rate. The discount rate goes by many names, including “capital discount rate”, “return on investment”, “cost of capital” and “rate of return”. At the other end of the spectrum, a company with a discount rate greater than 25% may be undervalued, and that discount rate also deserves justification. Dividend discount models, such as the Gordon Growth Model (GGM) for valuing stocks, are other examples of analyses that use discounted cash flows. Thus, an unlimited DCF projects a company's FCFF, which is discounted by the WACC, while a leveraged DCF forecasts a company's FCFE and uses the cost of capital as the discount rate. The discount rate is an essential input in any DCF model; in fact, it is arguably one of the most influential factors when it comes to deriving value from such an analysis.
If you've ever attended a finance class, you've learned that it uses a company's weighted average cost of capital (WACC) as its discount rate when creating such models. While there may be certain instances where a discount rate greater than 25% may be reasonable, it's important to provide detailed justification for why such an elevated figure has been chosen. Discounted cash flow analysis finds the present value of expected future cash flows using a discount rate. After forecasting expected cash flows, selecting an appropriate discount rate and then discounting those cash flows before adding them together; net present value (NPV) deducts the initial cost of investment from this sum. Once all cash flows are discounted to their current date equivalents; this total represents an investment's implied intrinsic value - usually that of public companies.
