INVESTMENT EXPLORED: What you need to know about the discount rate… and how it affects the price investors will pay
In this series, we break the jargon and explain a popular investment term or topic. Here it is discount rate.
Anything with the sale?
No – and confusingly, the term has two different meanings.
The first of these is the interest rate that the Federal Reserve, the US Federal Reserve — known as the Fed — charges banks on loans when they need an additional source of funding.
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The second meaning is an element in an analysis aimed at showing the viability of an investment. It is used by companies considering starting an acquisition of another company or deciding whether to tie up capital for a project.
In such cases, the discount rate is sometimes referred to as the “hurdle rate.”
Tell me more about the Fed’s policy rate
The loans the Fed makes to banks are usually granted overnight, but that period — the window — can be extended in emergencies, such as during the 2008-09 global financial crisis.
Such was the demand on these funds that in October 2008, shortly after the collapse of Lehman Brothers, discount rate borrowing reached $404 billion, up from the monthly average of $0.7 billion since 1959.
Why has the US discount rate increased?
Currently the discount rate is 1 percent; a year ago it was 0.25 percent.
The interest rate, set by the Fed’s Board of Governors, is one of the mechanisms the central bank uses to manage the money supply and hence inflation, which is the current priority. Jerome Powell, Fed Chairman, told the American people: “Inflation is far too high and we understand the hardship it is causing. We’re moving fast to bring it back down.’
What about the second meaning?
The discount rate is used in the DCF – Discounted Cash Flow analysis.
DCF, calculated in a complex formula, is a way of finding out if an investment is worth its current cost by analyzing its future earnings.
The calculation uses a discount rate that represents the return you want to make. It helps you determine the maximum amount you are willing to pay today for future returns, taking into account the risks involved.
Many stock market analysts rely on DCf to try and figure out what future cash flows will look like when examining companies’ accounts to determine if their shares are worth buying today.
Is this a reliable way to choose an investment?
The system has its critics.
It’s not a crystal ball, more of a guide: the goal is to make an informed decision.
If you can make an investment at a price less than the sum of the discounted cash flows, the investment may be undervalued, with the potential for a handsome payback.
If costs are greater than these cash flows, the investment could be overvalued.
Of course there is no guarantee.
What is discount rate? investing explained
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