What is discount rate? Investing Explained


INVESTING EXPLAINED: What you need to know about the discount rate… and how it affects the price investors will pay

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s discount rate. 

Something to do with the sales? 

No – and, confusingly, the term has two distinct different meanings. 

The first of these is the interest rate that the Federal Reserve, the US central bank – known as the Fed – charges banks for loans when they need a back-up source of funding. 

Right direction?: The system has its critics and it is not a crystal ball, more of a guide: the aim is to make an informed decision

The second meaning is an element in an analysis designed to show the viability of an investment. It is used by firms considering whether to launch a takeover of another company, or deciding whether to commit capital to a project. 

In such instances, discount rate is sometimes called the ‘hurdle’ rate. 

Tell me more about the Fed’s rate

The loans advanced by the fed to banks are usually made overnight but this period – the window – can be extended in times of emergencies, such as during the global financial crisis of 2008-09. 

Such was the requirement for these funds, that in October 2008, just after the fall of Lehman Brothers, discount rate borrowing reached $404billion against the monthly average of $0.7billion in the period since 1959. 

Why has the US discount rate been rising? 

At present, the discount rate is 1 per cent; a year ago it was 0.25 per cent. 

The rate, which is set by the fed’s board of governors, is one of the mechanisms the central bank uses to control the money supply and thus inflation, a priority at present. Jerome Powell, the fed chairman, told the American people: ‘Inflation is much too high and we understand the hardship it is causing. We’re moving expeditiously to bring it back down.’

What about the second meaning? 

The discount rate is used in DCF – discounted cash flow analysis. 

DCF, calculated in a complex formula, is a way of working out whether an investment is worth its current cost by analysing its future revenues. 

The calculation uses a discount rate, which is the return that you wish to achieve. it helps you determine the maximum that you are willing to pay today for a return at some time in the future, taking account of the risks involved. 

Many stock market analysts rely on DCf, attempting to work out what future cash flows will be, when scrutinising the accounts of companies to establish whether their shares are worth buying today.

Is this a reliable way of choosing an investment? 

The system has its critics. 

It is not a crystal ball, more of a guide: the aim is to make an informed decision. 

If you can make an investment at a cost below the sum of the discounted cash flows, the investment may be undervalued, with the potential for a handsome payback. 

If the cost is higher than those cash flows, the investment could be overvalued. 

Of course, there is no guarantee. 

Read more at DailyMail.co.uk