Discount rates are used to value stocks and businesses.
There are many types of valuation methods that we can use. For this article, information on “How To Find The Discount Rates” is used for valuation using the Discounted Cash Flow (DCF).
Understanding The Sources That Affect Discount Rates
I have always emphasized that in stock’s valuation, we have to understand the source of their value.
For example, when we are valuing stock of banks such as OCBC or POSB, we would need to know things like how are the assets of banks calculated- do we include the money people put in banks as the bank’s assets or liability? What are the laws and regulations that affect their value?
After calculating the value of the stock, we use the discount rates to find the present value of the cash flows that the firm is going to receive in the future.
To find the discount rates, we need to first understand the sources that affect it- which is risks- with risks, there comes variance of the stock returns.
Variance means the extent of changes in the stock price over time.
I know what you must be thinking. “What do you mean by risks? I want to straight away know how to find the discount rates for stocks’ valuation.” you may say.
Please be patient because risk, variance and discount rates are interconnected.
Let me first explain what do I consider as a risk. It is not all bad because there is the “good” side of risks.
Bad is when we get a return that is lower than expected, we call this downside risk.
Good is when we get a return that is higher than expected, we call this upside risk.
For example, when we start a business there are risks involved but those risks could be good or it could be bad. It is based on those risks that we make our decision on whether to invest in the business or not- similarly, it is based on the risks that we decide on the discount rates of stocks- to value and decide whether to buy or not.
Risks can be further categorized into diversifiable and non-diversifiable risk.
Diversifiable risk is also known as firm-specific risk. Some examples of them include project, competition and sector risk. For example, the recent Sete Brasil bankruptcy news is a firm-specific risk to companies like Keppel Corporation.
The non-diversifiable risk is also known as market risk. Some examples of them include exchange rates, political risk, interest rates changes and any news about the economy. For example during periods of political instability in countries like Greece last year, all of the stocks in the Greece’s stock market is affected very badly- indifferent on whether the underlying business operations of the stock is doing good or bad- the whole market is affected.
Essentially, Risks In Investing In Stocks Are The Chance Of Getting A Different Return Than Expected (The Variance).
Singapore Savings Bonds that gives a certain percentage yearly return can be considered as riskless– because there is not a chance that the investor would get a return that is different than the one they expected to make.
On the other hand, if let’s say we buy Coca-Cola stock (NYSE: KO) and we expect to make a 20% return in a year. If our actual return is different, this variance based on the difference between the expected and actual stock return is taken into account to calculate the discount rates.
In the next segment of this article, I will explain the concept of how firms raise the funds they need to buy their assets. They are able to raise funds traditionally by issuing debt or equity- these issuances have risks innate in them- the bigger the risks, the bigger the discount rates to use in valuing the firm.
The combination of the cost for firms to raise equity and debt for funding purposes is called the Weighted Average Cost of Capital (WACC)- which is used as the discount rates to value firms.
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