The discount rate is a critical factor in determining the present value of future cash flows in a discounted cash flow (DCF) analysis. It is usually the weighted average cost of capital (WACC) of a company, the required rate of return, or the limit rate investors expect to obtain relative to investment risk. The average discount rates used by most investors today are between 7.5% and 9.5%. In corporate finance, there are only a few types of discount rates that are used to discount future cash flows to the present.
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. The higher the discount rate, the lower the present value of future cash flows. Therefore, it is important to choose an optimal discount rate that accurately reflects the risk associated with an investment. For example, 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. When evaluating an investment opportunity, it is important to consider both the upside potential and downside risk associated with it.
If you choose to use a high discount rate, such as 12% or 15%, to discount future cash, it just means that you're willing to pay less today for future cash. 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. For simplicity, you can adjust the discount rate to see the effect of changes in the discount rate. Before making any decisions on an investment opportunity, it is important to consider all factors and determine what is an optimal discount rate for your particular situation. In conclusion, when evaluating an investment opportunity it is important to consider both the upside potential and downside risk associated with it.
The average discount rates used by most investors today are between 7.5% and 9.5%, while a stock discount rate range of 12% to 20%, more or less, is likely to be considered reasonable in a business valuation. A company with a discount rate greater than 25% may be undervalued and should be carefully evaluated before making any decisions.
