If shareholders expect a return of 12%, that is the rate that the company will use to calculate the Net Present Value (NPV). However, when it comes to truly usable discount rates, expect them to be within a range of 6 to 12%. This range is in line with 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. When analyzing an investment opportunity, the discount rate should be determined after the company has approached the project's free cash flow.
Once the company has reached a free cash flow figure, it can be discounted to determine the NPV. 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.
Using a high discount rate will give a lower rating than a low discount rate. The cost of capital refers to the minimum rate of return needed on an investment to make it worthwhile, while the discount rate is the rate used to discount future cash flows of an investment to the present value to determine if an investment will be profitable. 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. A NPV calculated using variable discount rates (if known for the duration of the investment) may better reflect the situation than one calculated from a constant discount rate for the entire duration of the investment.
