Discount rate

The annual rate at which future money is reduced to a present value, reflecting both the time you wait and the risk that the money does not arrive.

Example

Raising the rate from 10% to 11% cut one enterprise value from 15,928,152 to 14,003,132, a fall of 12.1%.

Important

It is the easiest input to move, cannot be checked against anything observable, and adjusting it looks exactly like refining a risk assessment. Fix it and justify it in writing before the first cash flow is entered.

Related terms

  • Discounted cash flow — Valuing an asset as the money it will produce, with each future amount reduced to reflect that money arriving later is worth less than money arriving now.
  • Present value — What an amount of money arriving in the future is worth today, once discounted at a chosen rate.
  • Sensitivity analysis — Recomputing a valuation with each uncertain input moved across the range you would defend, to see how much the answer depends on each one.

Lessons that explain it

  • Rates up, price down: the mechanism, and exactly how far — A bond's price is not an opinion. Given a yield, it is the present value of a schedule - and the size of the move when yields shift is a number you can compute in advance. (14 min)
  • IRR: the measure that knows about time, and what it assumes — IRR is the rate at which every cash flow discounts back to zero. It is the right tool for irregular timings, and it systematically flatters anything held briefly. (14 min)
  • Discounted cash flow: the method that shows its assumptions — A discounted cash flow states every assumption out loud, which is its great virtue and the reason it is so easy to abuse. The output moves enormously on inputs that cannot be observed. (14 min)
  • Work backwards: what would have to be true to justify this price? — Rather than producing your own valuation and comparing it with the price, take the price as given and solve for the growth or margins it assumes. Then judge whether those assumptions are plausible. (11 min)

All 578 terms in the Investing glossary