Some thoughts on Discount Rate

What is a discount rate in DCF? Most of us simply replace the discount rate “r” with risk-free return (eg. T-bill) or expected market return in CAPM (eg. 9% = 3% risk-free + 6% market premium). However, people hardly clarify their reasons behind these numbers. As long as an intrinsic value comes out of the formula, discount rate’s meaning is not critical.

But it is critical if you want to derive a reliable intrinsic value no matter for your bond or stock or even currencies investments.

What is a discount rate? In fact, the discount rate reflects an investor’s understanding of opportunity cost. Concretely speaking, a discount rate is the expected return of an alternative investment instead of the one you are making. For example, you can invest in T-bills without any risks and receive an annual return of 3%. You can also invest the money in stock market where you expect a higher return by taking some risks. The 3% return of T-bills is an opportunity cost of your investment. The same reason works for the CAPM model return. Following this logic, to determine an accurate and practical discount rate is to determine the opportunity cost.

In China, the temperature of real estate market is elevating like a rocket. An annual return of real estate investment in large cities in China can reach 20% - 25%. When observing this phenomena, investors and speculators may extract their money from stock market and inject these hot cash into real estate market, which further drives up the prices. At this time, the opportunity cost of investing in Chinese stock market is so high because people can simply invest in real estate and expect a higher return than stock market. However, when considering about the discount rate, we can not blindly use 20% or 25%, because the liquidity risk hidden in these numbers hardly exists in the stock / bond market. A discount rate is a secured return of opportunity cost.

The China real estate market is just an example. Determining discount rate is not a handy job. As the economic environment is changing, the opportunity cost is also changing, which leads to fluctuating discount rate and thus a fluctuating intrinsic value. Yes, the intrinsic value of a stock is varying. In my mind, figuring out the changing direction is an essential thing for a speculator. Figuring out the range of intrinsic value is an essential thing for an investor. Who determines the range of intrinsic value? The range of discount rate. Who determines the range of discount rate? The range of opportunity cost.