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    Posted by Shane McQuillan 18 Jul 2019
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    Damned Discount Rate! How to Sum up the Discount Rate to use in Your DCF Analysis

    There are a substantial number of reasons for why you would be working on, and often getting frustrated over, your own DCF Analysis. It could be that you're struggling to sum up the kind of value that's within particular company shares, their ongoing projects, or just trying to crunch the numbers for business budgeting, here is how to sum up the discount rate to use in your DCF Analysis

    For those of you that are otherwise unfamiliar with what a DCF Analysis is, here's some much-needed context. Generally - it's an acronym which stands for 'Discounted Cash Flow', and is used for anything where you need to:

    • Find the value of a whole business
    • Value a specific project or investment that a company has been involved with
    • Get a bond valuation
    • Calculate a company's share value
    • To value a specific property that's generating income
    • Value the benefits of any cost-saving initiatives within a company
    • Value anything that a company produces to generate cash flow.

    So, no matter where your business is in its lifespan, it's important to apply these discounts to any current and future earnings and to have to hand their own discount value.

    To start off: what should this discount value be? And that depends on the kind of company that you have.

    Sales as a Service (SaaS) companies that are more established, for example should have this be around 10%, while fledgeling startup companies should look at higher discount rates of 15-20%, the reason being that startups have to consider their long-term survivability, while established companies don't necessarily.

    So, on to calculating your discount rate.

    Your Companys WACC! Your Discount Rate Explained

    Size doesn't matter here, because the rule still applies - whenever you spend company money on something, you're spending your company capital. As a result, you need to consider what that capital means in costs for the company.

    This is where WACC (another acronym) comes in, which refers to the Weighted Average Cost of Capital. Much as the name suggests, this is the end number that's calculated in average compared to the amount of equity your company has relative to its debt.

    When we use this kind of model, it's worth pointing out that some companies do tend to factor in other elements for their business WACC, so feel free to use this for your discount rate while factoring in other elements in the future!

    So how do you actually go about calculating this? Using this foundation formula

    Ve - Value of Equity Vd - Value of Debt Ke - Cost of Equity Kd - Kd - Cost of Debt T - Corporate Tax Rate (10-25% depending on your company)

    So in finding out your company's WACC (no hidden jokes there), you'll be able to also find out the kind of Discounted Cash Flow.

    Between Reading and READING DCF

    There's a difference between actually reading and acknowledging your DCF, and actually understanding and factoring it into any future expenditure.

    You, of course, have to remember that old adage of 'speculate to accumulate,' so however your DCF comes out - that should reflect the kind of return you can expect from spending capital.

    Effectively, what your DCF can also tell you is the kind of associated value that you're willing to pay in relation to this DCF. For example -

    • If you manage to pay less than the forecasted DCF value, you can expect a higher rate of return that the discount rate
    • If, however, you pay more than what the DCF value is, your rate of return will be lower than this discount rate.

    Discounted Cash Flow - Its Limitations

    There's no denying that this DCF statistic is effective in the hands of any business and allows them to forecast monthly and annual returns on potential investments. The problem arises when these investments and spends become more complicated that DCFs start to meet their limitations.

    For example, if there's any kind of fluctuation in the risk-free rate changes and changing costs of capital over time can lead to the initial DCF analyses becoming invalidated, thus throwing your previous forecasts into the fog.