Discounted cash flow – a better way to calculate your cost of capital?

Discounted cash flow method, or DCF for short, is well known in business valuation. You forecast business earnings, assess business risk in the form of discount rate and calculate business value in present day dollars.

But you could also use the DCF method as a great way to calculate your discount rate. To do so, you make the assumption that the current stock price of a public company represents the market’s view of the rate of return that the investors will realize going forward.

In other words, the current price per share represents the present value of the total return, namely the expected dividends and stock appreciation. Put differently, the current stock price embodies the future returns discounted to today at a discount rate that equals the company’s cost of capital.

Discounted cash flow method can be used to figure out the discount rate

Let’s say you use the discounted cash flow method to calculate the value of a company. So you plug in the earnings forecast and a discount rate. But what if you know the present value of the company’s equity already? Then you can calculate the underlying, or implied, discount rate that gives you that business value.

Putting the discount rate first

Put differently, you turn the DCF calculation on its head. In fact, you solve the equation for the discount rate instead of the present value of the business itself.

The discounted cash flow math remains the same. But your inputs and outputs change depending on whether you use the method for business valuation or calculation of the discount rate.

In business valuation, you already know the discount rate and need to determine the value of the business. In estimating the cost of capital, you have the market value of the company’s equity as a given, and figure out the number for the discount rate that solves the DCF equation.

Turning the discounted cash flow upside down to get at the implied discount rate

Note one big difference though. Solving for the business value is a direct calculation. Just plug in the earnings forecast and the discount rate and crunch your business value number.

On the other hand, figuring out the discount rate given the present value of the company’s equity follows a sequence of guesses. In math language, you need to run a search for the discount rate that makes the DCF equation true.

In search of the discount rate

This iterative process is best accomplished using a computation that progressively converges to the desired discount rate. That is why the resulting answer is known as the implied discount rate.

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