What is a discount rate? And how it’s used to price shares (simplified)
A discount rate is the interest rate applied to the future earnings of a company, in order to determine what those earnings are worth in today’s dollars. By applying a discount rate to future earnings, investors can establish the net present value of a company and, thus, if the company is fairly priced. The actual discount rate used by an individual investor is subjective and usually based on current cash rates and the investor’s view on risk.
Usually, investors will apply higher discount rates to more speculative companies. For example, a start-up tech company planning to IPO in Hong Kong would generally attract a much higher discount rate, compared with an established global consumer staples business.
Discount rate in practice
As mentioned above, the core reason a discount rate is used is in order to calculate a company’s net present value (NPV).
A company’s NPV is significant when investor’s and analysts are forming a view on the attractiveness of a stock.
In the following steps, we’ll look at how a discount rate of 7.5% can be used to establish a company’s NPV.
Step 1 – Earnings
The investor would first calculate expected future maintainable earnings from the company’s operating activities, for up to 10 years. This would be based on earnings information provided by the company.
For the sake of this scenario we’ll say the expected future maintainable earnings of Company X is $70 million, it has no debt, and has 100 million shares on issue.
Step 2 – Estimated Value
From here, using Company X’s expected future maintainable earnings of $70 million and the discount rate of 7.5% we can calculate the estimate present value of the company using the following calculations.
Estimated Present Value = Expected Future Maintainable Earnings / Discount Rate.
So this is:
70 / 0.075 = $933.3 million
Estimated Value = $933.3 milion
Step 3 – Net Present Value of Shares
Now, you can calculate the net present value of shares in order to determine if the company is attractively priced, based on the discount rate applied.
To do this: Divide the Estimated Value calculated above ($933.3 million), with the number of shares on issue ($100 million)
933.3 / 100 = 9.33
Net Present Value of Company X = $9.33 per share (based on discount rate of 7.5%)
If Company X’s shares were trading or IPO’ing above $9.33, the investor might consider them to be overpriced. On the other hand, if they’re trading or IPO’ing below $9.33, the investor would likely consider Company X to be an attractive investment opportunity.
So, you can see why knowing what is a discount rate is crucial for serious investors.
A discount rate is an important factor in determining whether or not to invest in a stock. However, the process of determining a discount rate is highly dependent on the individual investor or analysts views on business risks, macro risk and the market environment. When one investor applies a 7.5% discount rate, another may apply a 9% discount rate, because they have different views and investment philosophies.
It is also important to remember when calculation the NPV of a company, you are highly dependent on the quality of reporting and data that can be extracted from it.