Practically speaking, you can think of the discount rate as the expected rate of return, or IRR without leverage. It can be thought of as the opportunity cost of making the investment. The opportunity cost, would be the cost related to the next best investment.
In other words, the discount rate should equal the level of return that similar stabilized investments are currently yielding. A discount rate is a representation of your level of confidence that future income streams will equal what you are projecting today.
In other words, it is a measure of risk. A higher discount rate relative to a lower discount rate generally means that there is more risk associated with the investment opportunity. Therefore, we should discount future cashflows by a greater percentage because they are less likely to be realized. Conversely, if the investment is less risky, then theoretically, the discount rate should be lower on the discount rate spectrum.
Therefore, the discount rate used when analyzing a stabilized class A apartment complex will be lower than the discount rate used when analyzing a ground-up shopping center development in a tertiary market. The higher the Discount Rate, the greater the perceived risk. The lower the Discount Rate, the smaller the perceived risk. Keep in mind that the level of risk is a function of both the asset-level risk as well as the business plan risk.
Asset risk is the product type, the market, the location etc. The business plan risk refers to the strategy behind the project. A ground-up development will have more business plan risk than a passive investment in a stabilized project.
Another way of thinking about a discount rate is through the Build-Up Method. This is a more academic approach than that of the opportunity cost approach. It is essentially a rate built by taking the risk free rate US Treasury and adding to it margins for the unique set of operating, market, and credit risks as well as a liquidity risk premium.
Then you can perform a DCF analysis that estimates and discounts the value of all future cash flows by cost of capital to gain a picture of their present values. If this value proves to be higher than the cost of investing, then the investment possibility is viable. Calculate the amount they earn by iterating through each year, factoring in growth. Bad news for WellProfit. To put it briefly, DCF is supposed to answer the question: "How much money would have to be invested currently, at a given rate of return, to yield the forecast cash flow at a given future date?
Discount rate is used primarily by companies and investors to position themselves for future success. For companies, that entails understanding the future value of their cash flows and ensuring development is kept within budget. For investors, the discount rate allows them to assess the viability of an investment based on that relationship of value-now to value-later.
Money, as the old saying goes, never sleeps. Owing to the rule of earning capacity , a dollar at a later point in time will not have the same value as a dollar right now. Present value PV , future value FV , investment timeline measured out in periods N , interest rate, and payment amount PMT all play a part in determining the time value of money being invested.
Being able to understand the value of your future cash flows by calculating your discount rate is similarly important when it comes to evaluating both the value potential and risk factor of new developments or investments. Knowing your discount rate is key to understanding the shape of your cash flow down the line and whether your new development will generate enough revenue to offset the initial expenses.
It is comprised of a blend of the cost of equity and after-tax cost of debt and is calculated by multiplying the cost of each capital source debt and equity by its relevant weight and then adding the products together to determine the WACC value.
Tutorial Video 2. Tutorial Video 1. View in HD. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses. If the company was a biotech with no revenue streams and only a single drug in phase 2 or 3 trials, the discount rate would be significantly higher.
Whatever rate you choose, never forget to apply a margin of safety to the final intrinsic value because no one can accurately predict the future. But note that a high discount rate may warrant a lower margin of safety — but that is up to the investor.
I have freedom to choose my discount rates based on my narrative and by keeping it consistent with my investment goals and strategy. Please be careful that you do not match your discount rate to the valuation you want to see. But rather, you should approach the valuation and discount rate process as a way to poke and prod to discover the fair value range of a stock.
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