The second step in the DCF process is the determination of the discount rate.
A discount rate is defined as the rate of return an investor would require to be induced to invest in the cash-flow stream being discounted. There are six important aspects of discount rates. Discount rates
- are affected by the market;
- vary with time;
- depend on what is being discounted;
- must be risk adjusted;
- are based on yields available on alternative investments; and
- are inflation adjusted.
Three basic external factors affect discount rates: (1) general economic conditions; (2) yields available on alternative investments; and (3) industry conditions and outlook. The process of analyzing the external factors provides the appraiser with a sense of what might affect the discount rate. The answers to a few basic questions may provide a wealth of information. For example, is the industry going to grow at 5 percent? At 10 percent? Is it stable? Is it shrinking? How will the industry’s growth affect the expectations for cash flow? If management says that the subject company is going to grow at 10 percent a year for the next 10 years, but the industry is stable or declining, that projection may not make sense.
There are three internal factors that affect discount rates: (1) financial risk, (2) operating risk, and (3) the risk associated with the estimation of the cash-flow stream.