Businessman Investor

Touching base with the rational business psyche of stock market investors

Friday, September 16, 2011

On Discount Rates, Required Rate of Return, and Conservative Purchase Price

Why do we discount something? We discount a future value because we want to know the right price to pay now to achieve that discount rate as our required rate of return. Or maybe we don't necessarily want to accurately achieve our target rate; we just want, at least, to estimate a conservative purchase price that will preserve capital and put some potential earnings exposure, leaving most of the actual returns to chance... Just maybe.
This is Part 1 of a Series

Discount rates often seem too complicated when they should be not. Because the idea behind them is similar to an interest rate. Interest rates, for most of us, are easier to comprehend because of their familiarity in everyday practical use. Say we have Php100 and a bank deposit placement offers a 10% interest rate per annum. Should we decide to put it there and hold it for a year, our Php100 will be Php110 [Php100 x (1+10%)]. It’s very straightforward and helps to answer the question: How much money will we get in the end? Or algebraically, the unknown being sought is FV (future value):

FV = PV x (1+i)^n

By contrast, if what is known and offered to us, instead, is a future value amount, the question now is: How much are we willing to pay for it now? Algebraically, after transposing the variables, our unknown this time is PV (present value):

PV = FV / (1+i)^n

So if we are offered Php110 and we want to achieve a 10% rate of return after a year, we should be paying Php100 [Php110/ (1+10%)]. The interest rate and discount rate are thus one of the same nature. The difference can be attributed to the circumstance—that is, the term interest rate is used if we’re talking about finding the future value of a principal amount we would want to invest now. The term discount rate, on the other hand, is spoken if we’re talking about finding a present value we would be willing to pay now provided we know what the future value outcome would be.

Implications of the Discount Rate on Projected Cash Flows

Following this very basic idea behind discount rates, we should therefore be aware that when we use discounted cash flow models (DCF), we should only be discounting projected cash flows at a rate we would want to achieve—and this is despite the plethora of literature written on what appropriate discount rate to use (some say it’s CAPM, some say it’s WACC, etc.). Because in the end of the day, you should understand why you have discounted those cash flows in the first place. And what simply makes sense is: because you require or you want to achieve that discount rate as your rate of return.

But what if not, exactly?

Alright, maybe I overdramatized on the issue of what appropriate discount rate to use—with my assertion that it should be a rate which you would require. Let me clarify, instead, that it can actually be any rate you want provided you understand why you’re using it as your discount rate. The whole point of projecting and discounting value is to arrive at a conservative purchase price in which capital preservation and rational potency of earnings can be achieved. And that, I think, is an insight worthy of contemplation. Continue to Part 2: Capital Preservation and Rational Potency of Earnings

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