Valuation course · Lesson 4 of 10
The discount rate turns future cash into today's dollars.
A dollar in ten years is worth less than a dollar today. The discount rate says how much less, and it is the input that you cannot look up.
A dollar later is worth less
If you can earn 9% a year elsewhere, $100 in one year is worth $100 divided by 1.09 today. That is the present value. Each extra year divides by 1.09 again.
| When you receive $100 | Value today at 9% |
|---|---|
| Year 1 | $91.74 |
| Year 5 | $64.99 |
| Year 10 | $42.24 |
| Year 20 | $17.84 |
| Year 30 | $7.54 |
Cash far in the future is worth little today. That is why a DCF depends so much on the hurdle and on the years after year 10.
Where the hurdle comes from
The capital asset pricing model gives one answer. The hurdle is the risk-free rate, plus beta times the equity risk premium. Beta measures how much the stock moves with the market.
For Example Co., we assume a risk-free rate of 4%, a beta of 1.0 and a premium of 5%. The hurdle is 9%. Each of the three inputs is an estimate, so the hurdle is an estimate too.
How much the hurdle matters
| Hurdle | Value per share |
|---|---|
| 7% | $37.34 |
| 8% | $29.28 |
| 9% | $23.92 |
| 10% | $20.11 |
| 11% | $17.27 |
One point on the hurdle moves the value by 16% to 22%. So do not trust a DCF that shows one value. Show the value at several hurdles, as our research reports do.
Key points
- Present value is future cash divided by one plus the hurdle, once for each year.
- The capital asset pricing model gives a hurdle from the risk-free rate, beta and a risk premium.
- The hurdle is an estimate. Always show the value at more than one hurdle.
Sources
- William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, The Journal of Finance, 1964, for the capital asset pricing model.