Q: I have seen and heard a number of references recently to the discount. I understand that it is a way of valuing shares and other investments and that it is affected by falling interest rates. Can you fill me in a bit more?
A: The discount rate is a way of estimating how much an investment’s future cash flows are worth in the present and, therefore, what price to put on the asset.
Investors buy stocks and other assets for future income and capital gains, so the benefits of an investment occur over a number of years. In order to compare costs and benefits over time, values need to be converted and expressed in today’s dollar value.
From an investor’s point of view, a future benefit needs to be converted into today’s dollars because future dollars have a different value to current dollar value.
In his book Capital Ideas, Peter Bernstein writes: “Money expected in the future is never worth as much as money in hand today. There is always uncertainty about whether the money will be there when the time comes.
“Even when the investor has every reason to expect that it will be, money to be received tomorrow cannot be invested to produce a return until tomorrow. Only money on hand today can be invested today.
“Therefore, the present value of future cash flows is always less than the face value of those payments.”
This is referred to as “discounting” future value. The discount rate is the percentage rate at which future values are reduced to bring them into line with current value.
The discount rate is usually based on the opportunity cost of capital, which is a measure of how the funds invested could be used otherwise.
Bernstein writes: “After investors have projected the long-run flow of dividends, they must decide what discount rate to apply. In choosing the appropriate rate, the available return on alternative and less risky assets like Treasury bills or high-grade bonds must be taken into account.”
Discount rates are in the news because one of their key components – the borrowing rate – has fallen in Australia this year, with three cash rate cuts and a lower 10-year bond rate. Rates are falling in other markets as well, most notably the United States.
Changing the discount rate has a big impact on the cost-benefit analysis of an investment. With a lower discount rate, an investment will deliver greater benefits.
Investment manager Roger Montgomery says: “The discount rate is referenced to the risk-free rate. So if global risk-free rates are falling, then finance theory would suggest that equity cash flows should be discounted as a lower discount rate, all else equal.
“As the discount rate falls, valuations increase.”