Discount Rate
What is future money worth today?
Category: General Finance
Difficulty: Beginner
Definition
The interest rate used to figure out what future money is worth today.
Why This Matters
Money you get tomorrow is worth less than money you get today. The discount rate helps you compare investments that pay you at different times.
Simple Example
If someone promises to pay you $100 next year, what’s that worth today?
- If you can earn 5% elsewhere, today’s value = $100 ÷ 1.05 = $95.24
- If you can earn 10% elsewhere, today’s value = $100 ÷ 1.10 = $90.91
The higher the discount rate, the less future money is worth today.
What Goes Into the Discount Rate
Risk-Free Rate - What you can earn on super-safe investments (Treasury bonds) - Your baseline return
Risk Premium - Extra return needed for taking risk - Riskier investments need higher discount rates
Inflation - Money loses buying power over time - Discount rate needs to account for this
Common Uses
Investment Analysis - Compare different investment opportunities - Decide if an investment is worth it
Business Decisions - Should we buy new equipment? - Is this project profitable?
Stock Valuation - What are future earnings worth today? - Higher discount rate = lower stock value
Practical Guidelines
Conservative Investors - Use higher discount rates (10-12%) - Demanding higher returns for taking risk
Aggressive Investors
- Use lower discount rates (6-8%) - Willing to accept lower returns
Rule of Thumb - Stock market average: ~10% - Adjust up for riskier investments - Adjust down for safer investments
Common Mistakes
- Using the same rate for all investments
- Forgetting to account for inflation
- Not adjusting for different risk levels
- Making the math too complicated
The Bottom Line
The discount rate asks: “What return do I need to make this investment worthwhile?”
Simple rule: Higher risk = higher discount rate = future money worth less today.
Further Reading
Foundational Concepts: - Time Value of Money - Investopedia explanation - Present Value Calculator - Free online tool
Academic Background: - Capital Asset Pricing Model - Sharpe (1964), framework for discount rates