Continuing on from our look at the terminal growth rate we now turn our attention to the discount rate assumption. The discount rate is one of the key assumptions in the Valuecruncher valuation.

Deciphering the discount rate

Before addressing the technical definition of the Valuecruncher discount rate it is important to understand what the discount rate is designed to capture. The discount rate reflects the required rate of return on the investment. The discount rate consists of two key components, the time value of money and risk.

Time Value of Money

The time value of money assumes that all other things being equal you would prefer have a $1 today as opposed to waiting until tomorrow, next year or retirement. To sacrifice the opportunity to use that $1 today an incentive is required. The time value of money is reflected in the risk free rate component of the discount rate.

Risk

When considering risk in a financial context NYU Professor Aswath Damodaran cites the Chinese symbol for risk which is a combination of the characters for danger (crisis) and opportunity.

This approach recognises that risk represents more than just downside outcomes. Drawing on Damodaran again:

“…risk in finance is defined in terms of variability of actual returns on an
investment around an expected return, even when those returns represent positive outcomes.”

Valuecruncher’s valuation considers the risk associated with the company’s forecast free cash flow.

Games of chance such as roulette have a discrete number of potential outcomes with explicitly defined returns and probabilities. The expected return, variability and therefore risk can be established relatively easily.

The risk associated with a company is the function of countless potential outcomes that reflect a multitude of company specific and macro factors.

Examples of risks associated with Apple’s future cash flows:

• How much will the new 3G iPhone and price point increase sales?
• Will the economic downturn impact on the company’s sales?
• How big will the mobile web be and what will be the iPhone’s role?
• Can Apple continue their successful development of new and improved products?

The impact and likelihood of these factors are not directly observable like the outcomes of the roulette wheel but all contribute to Apple Inc’s discount rate. This makes the process of identifying and quantifying risk one of the major challenges of the valuation process.

A technical definition of the Valuecruncher discount rate

The discount rate used in the Valuecruncher valuation is the nominal post-tax weighted average cost of capital (WACC). The weighted average cost of capital is a combination of the required rate of return of the company’s equity holders (shares/stocks) and debt holders (bonds/loans).

Valuecruncher applies the discount rate to the company’s forecast nominal post-tax free cash flow (FCF). The free cash flow is calculated as a function of Valuecruncher inputs revenue, profitability, capital expenditure, depreciation and tax.

Wake up!! That was meant to be the boring part

Calculating, estimating or guessing the discount rate for companies

As stated the discount rate reflects the required rate of return on both debt and equity. The debt component of the discount rate is relatively easy to estimate based on the lending terms the company enjoys i.e. what interest rate (coupon rate) does the company pay. The required rate of return of the equity component is a more difficult proposition.

Practitioners often draw on mathematical approaches such as the capital asset prising model (CAPM) and arbitrage pricing theory (APT) to estimate the required rate of return on equity. These like all approaches have their pro’s and con’s. Despite the mathematical fire power inherent in these models a subjective assessment must be made before they are incorporated into the discount rate. This subjective component relates to the relationship between the discount rate and the company’s forecast free cash flows. A discount rate calculated based on historic returns, alternative forecasts or expectations may not be consistent with the forecast free cash flow. Examples of this issue include when companies are shifting their focus (e.g. IBM’s restructuring) or the industry is in the process of dramatic change (e.g. newspapers).

There are extensive resources available online on calculating the discount rate:

• Investopedia
• Damodaran on Valuation (2nd Edition)
  
• Estimated discount rate for New Zealand listed companies - PwC Cost of Capital Report
• Estimated discount rate by industry for the United States - Aswath Damodaran’s discount rate table