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How do you choose an appropriate discount rate for a DCF valuation?

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Discounted cash flow (DCF) is a method of valuing a project, company, or asset based on its future cash flows. It estimates the present value of those cash flows by applying a discount rate, which reflects the risk and opportunity cost of investing in the project. But how do you choose an appropriate discount rate for a DCF valuation? In this article, we will explore some factors and methods that can help you determine the best discount rate for your analysis.

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1 The concept of discount rate

The discount rate is the rate of return that you require or expect to earn from investing in the project. It represents the minimum return that you would accept for investing your money elsewhere. The higher the discount rate, the lower the present value of the future cash flows, and vice versa. The discount rate should reflect the riskiness and uncertainty of the project, as well as the time value of money, which means that a dollar today is worth more than a dollar in the future.

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2 The cost of capital approach

One common way to estimate the discount rate is to use the cost of capital approach, which calculates the weighted average cost of capital (WACC) of the project or the company. The WACC is the average rate of return that the project or the company needs to pay to its investors, including debt holders and equity holders. The WACC can be calculated by multiplying the cost of each source of capital by its proportion in the capital structure, and then adding them up. The cost of debt can be estimated by using the interest rate on the debt, adjusted for taxes. The cost of equity can be estimated by using the capital asset pricing model (CAPM), which considers the risk-free rate, the market risk premium, and the beta of the project or the company.

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Robert Reardon

Ph.D. Candidate at Florida Atlantic University ? Finance & Entrepreneurship ? Statistics, Crowdfunding, Fintech, and Law
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Because Preferred Stock is considered a hybrid form of financing (between debt and equity), if a company has preferred stock in its capital structure we must also include an estimate of the cost of preferred stock in our calculation of WACC. This can be calculated by dividing the preferred stock dividend per share by the current price of preferred stock.

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Laura Fuquay

Strategic Finance / Accounting / M&A and Integration / Change Management / Team Excellence
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Utilizing WACC is useful for normal course of business investment decisions such as capital asset replacements, expansions and optimization. Typically there are two or more options which bear commiserate risk with disparate cash flows.

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3 The hurdle rate approach

Another way to estimate the discount rate is to use the hurdle rate approach, which sets the discount rate based on a target or minimum rate of return that the project or the company must achieve. The hurdle rate can be based on various factors, such as the industry average, the company's historical performance, the investors' expectations, or the management's goals. The hurdle rate should be higher than the WACC, to account for the risk and uncertainty of the project, and to provide a margin of safety. The hurdle rate can also vary depending on the stage and type of the project, such as research and development, expansion, or acquisition.

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Laura Fuquay

Strategic Finance / Accounting / M&A and Integration / Change Management / Team Excellence
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The hurdle rate differs from the WACC rate as it is based upon expected return rates rather than actual company cost of capital. This is particularly important for publicly traded companies making large investment decisions as well as start-up companies with limited cash and need for more expedient returns or incremental funding.

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4 The sensitivity analysis

A third way to estimate the discount rate is to use the sensitivity analysis, which tests how the present value of the future cash flows changes when the discount rate changes. The sensitivity analysis can help you evaluate the range and impact of different discount rates on the valuation, and identify the break-even point where the present value equals the initial investment. The sensitivity analysis can also help you compare different scenarios and assumptions, and assess the robustness and reliability of your valuation.

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Laura Fuquay

Strategic Finance / Accounting / M&A and Integration / Change Management / Team Excellence
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I’m general, the discount rate should be held at a constant when adjusting various assumptions and scenarios in the cash flow model. I’m this way, the low and high case valuations can be determined based upon a constant assumed risk and different potential outcomes.

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5 The market data approach

A fourth way to estimate the discount rate is to use the market data approach, which uses the observed or implied discount rates of comparable projects or companies in the market. The market data approach can help you benchmark your project or company against similar or relevant peers, and adjust for any differences or premiums. The market data approach can also help you incorporate the market expectations and sentiments into your valuation, and reflect the current and future conditions and trends. However, the market data approach may not be always available or reliable, depending on the availability and quality of the data.

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Shiva Sharma

Finance Manager @ Walmart | USC Marshall MBA | Ex-Amazon
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One assumption when considering average discount rates for comparable companies is that the comps have similar capital structures. If we have reasonable estimates of the capital structures of the comparable companies, we can walk back the leveraged amount and get unlevered beta before averaging. Finally, we can add back the effect of leverage for the company being evaluated. This removes the effect of differences in the capital structure and ratio of debt.

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6 The judgment and intuition approach

A fifth way to estimate the discount rate is to use the judgment and intuition approach, which relies on your own experience, knowledge, and intuition to determine the best discount rate for your project or company. The judgment and intuition approach can help you incorporate your personal or professional insights and opinions into your valuation, and adjust for any specific or unique factors that may affect your project or company. The judgment and intuition approach can also help you balance between the quantitative and qualitative aspects of your valuation, and avoid over-relying on formulas or models. However, the judgment and intuition approach may also be subjective or biased, depending on your perspective and preferences.

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Laura Fuquay

Strategic Finance / Accounting / M&A and Integration / Change Management / Team Excellence
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Many times companies begin with either their WACC, their hurdle rate or the market rate then use intuition based upon the risk of the investment and ability to derive the desired outcomes to adjust the base rate up or down.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How do you choose an appropriate discount rate for a DCF valuation?

1

2

3

4

5

6

7

1 The concept of discount rate

2 The cost of capital approach

3 The hurdle rate approach

4 The sensitivity analysis

5 The market data approach

6 The judgment and intuition approach

7 Here’s what else to consider

Budgeting & Forecasting

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How do you choose an appropriate discount rate for a DCF valuation?

1

2

3

4

5

6

7

1 The concept of discount rate

2 The cost of capital approach

3 The hurdle rate approach

4 The sensitivity analysis

5 The market data approach

6 The judgment and intuition approach

7 Here’s what else to consider

Budgeting & Forecasting

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