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23 - What is a good Discount Rate to use for Discounted Cash Flow Calculations?

The DIY Investing Podcast: Value Investing | Fundamental Analysis | Mental Models | Business Management

Release Date: 04/21/2019

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Books Referenced in this Podcast

  • Stocks for the Long Run by Jeremy Siegel

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode23

Trey's Discount Rates:

  • Nominal Discount Rate = 10%
  • Real Discount Rate = 6.5%
  • Long-Run Inflation Expectations 3.5%

How to Select a Good Discount Rate:

Your discount rate should be based upon the rate of return you expect to earn on your investments. If you want or need to earn 8% on your investments, then your discount rate should be 8%. 

If you want or need to earn 10% on your investments, then your discount rate should be 10%. 

When to use Nominal versus Real Discount Rate:

You should use a Nominal discount rate when you are uncertain whether the company you are analyzing will be able to always grow their earnings at least at the rate of inflation. 

You should use a Real discount rate when you are confident that a company will be able to automatically adjust their prices at least as fast as the inflation rate. In other words, the company must have pricing power. This behavior is typically only seen in high-quality companies. 

Use the Same Discount Rate for ALL Companies

The discount rate you use heavily impacts the result of your valuation analysis. Therefore, it is critical to base this discount rate off of your expected rate of return. 

You should also not adjust the discount rate you use based upon the risk of one company versus another. If you make this mistake, then you are likely investing in companies that are too risky to make reliable forward estimates of long-run earnings. 

If you find yourself wanting to use a higher discount rate for a single company, take that as a red flag.