{"id":20442,"date":"2019-05-02T12:46:07","date_gmt":"2019-05-02T17:46:07","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/?p=20442"},"modified":"2025-07-30T19:18:07","modified_gmt":"2025-07-31T00:18:07","slug":"how-to-calculate-discount-rate","status":"publish","type":"post","link":"https:\/\/breakingintowallstreet.com\/how-to-calculate-discount-rate\/","title":{"rendered":"How to Calculate the Discount Rate in a DCF"},"content":{"rendered":"<p><strong>Table of Contents:<\/strong><\/p>\n<ul>\n<li><strong>0:39:<\/strong> Intuitive Explanation of the Discount Rate and WACC<\/li>\n<li><strong>5:53:<\/strong> Discount Rate Assumptions<\/li>\n<li><strong>11:43:<\/strong> How to Calculate the Cost of Equity<\/li>\n<li><strong>21:05:<\/strong> How to Calculate and Use WACC<\/li>\n<li><strong>24:55:<\/strong> Summary and Preview<\/li>\n<\/ul>\n<div class=\"text-center text-btn\"><a class=\"btn tertiary orange x-large\" href=\"https:\/\/breakingintowallstreet.com\/biws-premium\/\" target=\"_blank\" rel=\"noopener noreferrer\">Premium Course Signup<\/a>\n<\/div>\n<h2>Discount Rate Meaning and Explanation<\/h2>\n<p>The Discount Rate goes back to that <strong>big idea<\/strong> about valuation and the most important finance formula:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter size-full wp-image-20421\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075840\/Tutorial-01-Valuation-Formula.jpg\" alt=\"Company Valuation Formula\" width=\"986\" height=\"210\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075840\/Tutorial-01-Valuation-Formula.jpg 986w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075840\/Tutorial-01-Valuation-Formula-300x64.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075840\/Tutorial-01-Valuation-Formula-768x164.jpg 768w\" sizes=\"(max-width: 986px) 100vw, 986px\" \/><\/p>\n<p>The <strong>Discount Rate<\/strong> represents <strong>risk<\/strong> and <strong>potential returns<\/strong>, so a higher rate means more risk but also higher potential returns.<\/p>\n<p>The <strong>Discount Rate<\/strong> also represents your <strong>opportunity cost<\/strong> as an investor: if you were to invest in a company like Michael Hill, what might you earn by investing in other, similar companies in this market?<\/p>\n<p>Normally, you use something called <strong>WACC<\/strong>, or the \u201cWeighted Average Cost of Capital,\u201d to calculate the Discount Rate.<\/p>\n<p>The name means what it sounds like: you find the \u201ccost\u201d of each form of capital the company has, weight them by their percentages, and then add them up.<\/p>\n<p>\u201cCapital\u201d just means \u201ca source of funds.\u201d So, if a company borrows money in the form of Debt to fund its operations, that Debt is a form of capital.<\/p>\n<p>And if it goes public in an IPO, the shares it issues, also called \u201cEquity,\u201d are a form of capital.<\/p>\n<h2>How to Calculate Discount Rate: WACC Formula<\/h2>\n<p>The formula for WACC looks like this:<\/p>\n<p><strong>WACC<\/strong> = Cost of Equity * % Equity + Cost of Debt * (1 \u2013 Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock<\/p>\n<p>Finding the percentages is basic arithmetic \u2013 the hard part is estimating the &#8220;cost&#8221; of each one, especially the Cost of Equity.<\/p>\n<p><img decoding=\"async\" class=\"aligncenter size-large wp-image-20443\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075837\/Tutorial-02-WACC-Formula-1024x618.jpg\" alt=\"WACC Formula\" width=\"1024\" height=\"618\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075837\/Tutorial-02-WACC-Formula-1024x618.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075837\/Tutorial-02-WACC-Formula-300x181.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075837\/Tutorial-02-WACC-Formula-768x463.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075837\/Tutorial-02-WACC-Formula.jpg 1184w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n<p>The <strong>Cost of Equity<\/strong> represents potential returns from the company\u2019s stock price and dividends, and how much it \u201ccosts\u201d the company to issue shares.<\/p>\n<p>For example, if the company\u2019s dividends are 3% of its current share price, and its stock price has increased by 6-8% each year historically, then its Cost of Equity might be between 9% and 11%.<\/p>\n<p>The <strong><a href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/cost-of-debt\/\">Cost of Debt<\/a><\/strong> represents returns on the company\u2019s Debt, mostly from interest, but also from the market value of the Debt changing \u2013 just like share prices can change, the value of Debt can also change.<\/p>\n<p>For example, if the company is paying a 6% interest rate on its Debt, and similar companies are as well, meaning the market value of Debt is close to its value on the Balance Sheet, then the Cost of Debt might be around 6%.<\/p>\n<p>Then, you also need to multiply that by (1 \u2013 Tax Rate) because Interest paid on Debt is tax-deductible. So, if the Tax Rate is 25%, the After-Tax Cost of Debt would be 6% * (1 \u2013 25%) = 4.5%.<\/p>\n<p>The <strong>Cost of Preferred Stock<\/strong> is similar because Preferred Stock works similarly to Debt, but Preferred Stock Dividends are not tax-deductible and overall rates tend to be higher, making it more expensive.<\/p>\n<p>So, if the Preferred Stock Coupon Rate is 8%, and its market value is close to its book value because market rates are also around 8%, then the Cost of Preferred Stock should be around 8%.<\/p>\n<h2>Discount Rate Meaning: WACC in One Sentence<\/h2>\n<p><strong>WACC represents what you would earn each year, over the long term, if you invested proportionally in the company\u2019s entire capital structure.<\/strong><\/p>\n<p>So, let\u2019s say this company uses 80% Equity and 20% Debt to fund its operations, and that it has a 25% effective tax rate.<\/p>\n<p>You decide to invest $1,000 in the company proportionally, so you put $800 into its Equity, or its shares, and $200 into its Debt.<\/p>\n<p>We said before that the Cost of Equity was between 9% and 11%, so let\u2019s call it 10%.<\/p>\n<p>We know the After-Tax Cost of Debt is 4.5% as well.<\/p>\n<p>So, WACC = 10% * 80% + 4.5% * 20% = 8.9%, or $89 per year.<\/p>\n<p>That does <em>not<\/em> mean we will earn $89 in cash per year from this investment; it just means that if we count everything \u2013 interest, dividends, and eventually selling the shares at a higher price in the future \u2013 the annualized average might be around $89.<\/p>\n<p>WACC is more about being \u201croughly correct\u201d than \u201cprecisely wrong,\u201d so the <em>rough range<\/em>, such as 10% to 12% vs. 5% to 7%, matters a lot more than the exact number.<\/p>\n<h2>How to Calculate Discount Rate in Excel: Starting Assumptions<\/h2>\n<p>To calculate the Discount Rate in Excel, we need a few starting assumptions:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter size-full wp-image-20444\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075836\/Tutorial-02-How-to-Calculate-Discount-Rate-in-Excel.jpg\" alt=\"How to Calculate Discount Rate in Excel\" width=\"531\" height=\"184\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075836\/Tutorial-02-How-to-Calculate-Discount-Rate-in-Excel.jpg 531w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075836\/Tutorial-02-How-to-Calculate-Discount-Rate-in-Excel-300x104.jpg 300w\" sizes=\"(max-width: 531px) 100vw, 531px\" \/><\/p>\n<p>The Cost of Debt here is based on Michael Hill&#8217;s Interest Expense \/ Average Debt Balance over the past fiscal year. That&#8217;s 2.69 \/ AVERAGE(35.213,45.034), so it&#8217;s 6.70%. here.<\/p>\n<p>This is a &#8220;rough estimate,&#8221; and there are some problems with it (e.g., What if the market value of Debt changes? What if that doesn&#8217;t represent the cost to issue *new* Debt?) but we&#8217;ll go with it for now in this quick analysis.<\/p>\n<p>To calculate the Cost of Equity, we\u2019ll need the <strong>Risk-Free Rate<\/strong>, the <strong>Equity Risk Premium<\/strong>, and <strong>Levered Beta.<\/strong><\/p>\n<p><strong>Cost of Equity<\/strong> = Risk-Free Rate + Equity Risk Premium * Levered Beta<\/p>\n<p>The <strong>Risk-Free Rate (RFR)<\/strong> is what you might earn on &#8220;safe&#8221; government bonds in the same currency as the company&#8217;s cash flows \u2013 Michael Hill earns in CAD, NZD, and AUD, but reports everything in AUD, so we\u2019ll use the yield on 10-Year Australian government bonds, which was 2.10% at the time of this case study.<\/p>\n<p>You can find up-to-date <a href=\"https:\/\/countryeconomy.com\/bonds\/australia\" target=\"_blank\" rel=\"noopener noreferrer\">data on Australian government bond yields here<\/a>, and you can do simple Google searches to find them for other countries.<\/p>\n<p>The <strong>Equity Risk Premium (ERP)<\/strong> is the amount the stock market is expected to return each year, on average, above the yield on &#8220;safe&#8221; government bonds. We link it to the stock market of the country the company operates in (mostly Australia here).<\/p>\n<p>You can find estimates for this number in different countries online; <a href=\"http:\/\/pages.stern.nyu.edu\/~adamodar\/New_Home_Page\/datafile\/ctryprem.html\" target=\"_blank\" rel=\"noopener noreferrer\">Damodaran&#8217;s data on the ERP is the best free resource for this<\/a>.<\/p>\n<p>At the time of this case study, the Australian ERP was 5.96% based on this data.<\/p>\n<p><strong>Levered Beta<\/strong> tells us how volatile this stock is relative to the market as a whole, factoring in intrinsic business risk and risk from leverage (Debt).<\/p>\n<p>If it\u2019s 1.0, then the stock follows the market perfectly and goes up by 10% when the market goes up by 10%; if it\u2019s 2.0, the stock goes up by 20% when the market goes up by 10%.<\/p>\n<h2>How to Calculate the Cost of Equity<\/h2>\n<p>We could use the company&#8217;s historical &#8220;Levered Beta&#8221; for this input, but we usually like to look at <strong>peer companies<\/strong> to see what the overall risks and potential returns in this market, across different companies, are like.<\/p>\n<p>We could look up &#8220;Beta&#8221; for each company and take the median, but Beta on sites like Google Finance, Capital IQ, Bloomberg, etc. reflects both <strong>inherent business risk<\/strong> and <strong>risk from leverage<\/strong>.<\/p>\n<p>So, we must &#8220;un-lever Beta&#8221; for each company to determine the \u201caverage\u201d inherent business risk for these types of companies:<\/p>\n<p><strong>Unlevered Beta<\/strong> = Levered Beta \/ (1 + Debt\/Equity Ratio * (1 \u2013 Tax Rate) + Preferred\/Equity Ratio)<\/p>\n<p>This formula ensures that Unlevered Beta is always less than or equal to Levered Beta since we\u2019re removing the risk from leverage.<\/p>\n<p>We use VLOOKUP in Excel to find the Debt, Equity, and Preferred Stock for each company in the \u201cPublic Comps\u201d tab, but you could find these figures on Google Finance and other sources if you don\u2019t have the time\/resources to extract them manually.<\/p>\n<p>You can see the Unlevered Beta formula and output for each company below:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter size-large wp-image-20445\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Unlevered-Beta-Calculation-1024x281.jpg\" alt=\"Unlevered Beta Calculation\" width=\"1024\" height=\"281\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Unlevered-Beta-Calculation-1024x281.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Unlevered-Beta-Calculation-300x82.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Unlevered-Beta-Calculation-768x211.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Unlevered-Beta-Calculation.jpg 1242w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n<p>Michael Hill, like most companies, has more than just \u201cinherent business risk\u201d since it also carries Debt, so now we need to &#8220;re-lever&#8221; this median Unlevered Beta based on the company&#8217;s current or targeted capital structure to reflect that additional risk from leverage.<\/p>\n<p>To do that, we can reverse the formula for Unlevered Beta:<\/p>\n<p>Unlevered Beta = Levered Beta \/ (1 + Debt\/Equity Ratio * (1 \u2013 Tax Rate) + Preferred\/Equity Ratio)<\/p>\n<p>We multiply both sides by the denominator to isolate Levered Beta on the right side:<\/p>\n<p>Unlevered Beta * (1 + Debt\/Equity Ratio * (1 \u2013 Tax Rate) + Preferred\/Equity Ratio) = Levered Beta<\/p>\n<p><strong>Levered Beta<\/strong> = Unlevered Beta * (1 + Debt\/Equity Ratio * (1 \u2013 Tax Rate) + Preferred\/Equity Ratio)<\/p>\n<p>When re-levering Beta, we like to use <em>both<\/em> the company\u2019s current capital structure and the median capital structure of the peer companies, to get different estimates and see the range of potential values.<\/p>\n<p>Once we have that, we can then plug this Levered Beta number into the formula for Cost of Equity to calculate that:<\/p>\n<p><strong>Cost of Equity<\/strong> = Risk-Free Rate + Equity Risk Premium * Levered Beta<\/p>\n<p>You can see the results of these slightly different Cost of Equity calculations below:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter size-large wp-image-20446\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Cost-of-Equity-Calculation-1024x199.jpg\" alt=\"Cost of Equity Calculation\" width=\"1024\" height=\"199\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Cost-of-Equity-Calculation-1024x199.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Cost-of-Equity-Calculation-300x58.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Cost-of-Equity-Calculation-768x149.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075835\/Tutorial-02-Cost-of-Equity-Calculation.jpg 1252w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n<p>Here, the Cost of Equity is always between 9% and 10% regardless of the exact number we use for Levered Beta, which is good since we want a range \u2013 but a relatively narrow range.<\/p>\n<h2>How to Calculate Discount Rate: Putting Together the Pieces for WACC<\/h2>\n<p>Once again, the main question here is \u201cWhich values do we for the percentages Equity, Debt, and Preferred Stock? The company\u2019s current percentages, or those of peer companies?\u201d<\/p>\n<p>There\u2019s no definitive answer, so we use different approaches here \u2013 one based on peer companies and two based on the company\u2019s current percentages \u2013 and average them:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-20447 size-large\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075834\/Tutorial-02-WACC-Calculations-1024x364.jpg\" alt=\"How to Calculate Discount Rate: WACC Calculations\" width=\"1024\" height=\"364\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075834\/Tutorial-02-WACC-Calculations-1024x364.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075834\/Tutorial-02-WACC-Calculations-300x107.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075834\/Tutorial-02-WACC-Calculations-768x273.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075834\/Tutorial-02-WACC-Calculations.jpg 1040w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n<p>This result tells us that WACC for Michael Hill is most likely between 8.50% and 9.50%.<\/p>\n<h2>How to Discount the Cash Flows and Use the Discount Rate in Real Life<\/h2>\n<p>Finally, we can return to the DCF spreadsheet, link in this number, and use it to discount the company\u2019s Unlevered FCFs to their Present Values using this formula:<\/p>\n<p><strong>Present Value of Unlevered FCF in Year N<\/strong> = Unlevered FCF in Year N \/((1+Discount_Rate)^N)<\/p>\n<p>The denominator gets bigger each year, so the Present Value is a lower and lower percentage of the Future Value as time goes by.<\/p>\n<p>You can see that illustrated in the screenshot below:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter size-large wp-image-20448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075833\/Tutorial-02-Discounting-Cash-Flows-1024x225.jpg\" alt=\"Discounting Cash Flows\" width=\"1024\" height=\"225\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075833\/Tutorial-02-Discounting-Cash-Flows-1024x225.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075833\/Tutorial-02-Discounting-Cash-Flows-300x66.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075833\/Tutorial-02-Discounting-Cash-Flows-768x169.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/05\/19075833\/Tutorial-02-Discounting-Cash-Flows.jpg 1478w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this second free tutorial, you\u2019ll learn what the Discount Rate means intuitively, how to calculate the Cost of Equity and WACC, and how to use the Discount Rate in a DCF analysis to value a company\u2019s future cash flows.<\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[2334],"tags":[],"class_list":["post-20442","post","type-post","status-publish","format-standard","hentry","category-discounted-cash-flow"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/posts\/20442","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/comments?post=20442"}],"version-history":[{"count":6,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/posts\/20442\/revisions"}],"predecessor-version":[{"id":31802,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/posts\/20442\/revisions\/31802"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=20442"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/categories?post=20442"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/tags?post=20442"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}