When discussing the discount rate in discounted cash flow (DCF) valuation, practitioners often default to calculating it through the weighted average cost of capital (WACC), with the cost of equity derived via the Capital Asset Pricing Model (CAPM). The cost of equity, in turn, is often anchored to the historical return on equities, typically benchmarked to the S&P 500’s long-term average return of approximately 10-12% since inception. This approach yields relatively stable discount rates regardless of where we are in the business cycle, with minor adjustments to account for differences in company betas and leverage.
However, this traditional approach warrants deeper examination.
Is the discount rate:
A required rate of return for investors?
The opportunity cost of capital?
Simply an average historical return on comparable assets, as calculated through CAPM?
Let us explore these interpretations and challenge the conventional methodology.
1. Discount Rate as a Required Rate of Return
If we define the discount rate as the required rate of return, the focus shifts to what an individual investor expects from an investment. This expectation is often informed by historical returns and personal financial goals. For example, some investors may consistently target a 7% annual return, applying this rate universally across investments, regardless of the underlying risk profile.
This fixed-rate approach reflects the subjective nature of risk assessment. Risk perception is deeply personal and challenging to quantify objectively. Many investors operate with a binary decision framework: they either pursue investments that meet or exceed their expected return (e.g., 7%) or they do not invest at all.
What’s striking is that such investors may not vary their required rate of return based on the riskiness of the investment. They are unlikely to demand 20% for high-risk ventures or settle for 2% for near-risk-free opportunities. Instead, they remain focused on finding investments within their preferred asset classes that align with their return expectations, regardless of risk nuances.
2. Discount Rate as the Opportunity Cost of Capital
A more dynamic view considers the discount rate as the opportunity cost of capital. Here, investor expectations are shaped by both historical empirical returns and current market conditions. For instance, during a recession when equity valuations are low and P/E ratios are compressed, intrinsic company returns on invested capital (ROIC) tend to dominate. In such environments, equity returns often rise to the range of 12-16% due to favorable valuations. Consequently, investors applying this range of discount rates keep valuations conservative.
Conversely, in bull markets characterized by inflated asset prices or speculative bubbles, alternative investment opportunities offer lower expected returns, often around 6-8%. This environment leads to lower discount rates being applied, inflating valuations further and reinforcing the bubble dynamic.
3. Discount Rate as an Average Historical Return on Comparable Assets (CAPM)
The CAPM-derived discount rate equates the cost of equity to the average historical return on similar assets, adjusted for company-specific beta and leverage. This method assumes that historical equity returns, such as the S&P 500’s 10-12%, represent a reasonable proxy for future expectations. While this approach provides a standardized methodology, it may fail to reflect real-time market dynamics or investor-specific preferences.
For example, if all equity investors were to uniformly apply the historical 10-12% return as a discount rate, they might disregard current market conditions—whether those conditions signal opportunity (e.g., during recessions) or risk (e.g., during asset bubbles). Such rigidity can lead to valuations that are out of sync with prevailing realities.
Challenging the Status Quo
The reliance on CAPM and historical benchmarks like the S&P 500’s return has practical limitations. It assumes that market conditions and investor behaviors remain consistent over time, an assumption that oversimplifies the dynamic nature of financial markets. Investors, particularly those attuned to market cycles, do not always adhere to static discount rates. Instead, they adjust their expectations based on prevailing conditions, blending historical insights with forward-looking assessments.
This leads to a fundamental question: should business valuation practitioners continue to rely on CAPM and historical averages, or should they adopt a more nuanced, investor-specific approach? By viewing the discount rate as a flexible concept shaped by required returns, opportunity costs, and market dynamics, we can move toward valuations that better reflect real-world complexities.
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