Choosing a Discount Rate for
Discounted Cash Flow Stock Valuation
The discount rate is an interest rate used to determine how much future cash flows are worth today. Discount rates are used in valuation analysis when cash flows are expected to be received over long periods of time. The discount rate is expressed as an annual percentage and is one of the critical components in discounted cash flow analysis for stock valuation.
About Discounted Cash Flow Analysis
Discounted Cash flow analysis is believed by many investors to be the most reliable formula for stock valuation. Benjamin Graham, “the father of value investing”, performed discounted cash flow analysis to evaluate stock investment opportunities. Under the DCF approach for stock valuation, we recognize that a company is worth the total amount of cash it will generate over its lifetime. To estimate the value of that company today, these future cash flows need to be discounted to their present value. We can then assign a current or “intrinsic” value to stock of that company and compare it against the current price per share to evaluate the investment opportunity.
Choosing an Appropriate Discount Rate
Some of the factors involved in choosing a discount rate include:
• What it costs you to acquire the money to invest as your return must surpass this cost for the investment to be worthwhile
• What return would you expect to earn in an alternative investment (opportunity cost)
• How you expect to be compensated for risk (business, inflation, and financial)
Warren Buffet, it is said, uses a minimum discount rate of 10%. Very conservative value investors will often use 15%. Other investors may choose a discount rate based on the market cap of the company under consideration. Under this approach, you would assign a higher discount rate to the smaller-cap stocks to account for the higher level of risk typically associated with these smaller companies. For example:
• 13% - 15% for small caps
• 11% - 12% for mid caps
• 10% for large caps
Using the Stock Research Pro DCF Calculator
To discount the future earnings of a company to a present value, the Discounted Cash Flow Calculator assumes two stages of growth:
• A 5-year period in which you estimate the earnings growth rate for each year individually
• A “terminal” growth rate of 3%: It is common to use this terminal growth rate assumption, based on the long-term track record of economic growth in the United States
Weighted Average Cost of Capital and Discount Rates
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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