Accountants, investors, and many large corporates around the world use the discount rate as the go-to metric for pricing any asset that has elements of uncertainties in its future economic value.
In the context of business, discount rates simply provide a guide for analysts in terms of determining what an appropriate investment value should be, that is, based on a series of estimated future cash flows.
It broadly takes into account the perceived risks in execution as well as the opportunity costs of deploying that capital.
But perhaps more importantly, it represents the expected return of the investor.
The bigger picture
"The complexities exist to give bankers and lawyers a reason to exist."
I had often thought:
How were business deals discussed and negotiated decades ago before the invention of computers and spreadsheets? How did investors made the call for investing $10 million in a particular real estate that gave say a 7% yield over buying a cluster of houses in another remote part of the country? How did they know that investing $200,000 in the neighbourhood bakery would generate a return of 15% over the next three years?
How did shareholders split equity? Did they have drag and tag clauses, used term sheets and signed MOUs?
I think we had relatively simpler lives back in the days.
Deals were probably mostly executed as gentlemen agreements or done in the presence of credible witnesses which gave the covenant legal effect. But aside from the law, your word meant everything, and high-level numbers were calculated with no one needing to build complicated financial models.
Today we have powerful spreadsheets that can do intricate calculations on valuations and IRRs to three decimal places.
We can also write code in spreadsheets that precisely calibrate 10 years of projected cash flows to comply with a DSCR[1] of exactly 1.3x, no more no less.
By embedding programming code into spreadsheets, you can even automate certain calculations to value stock options, run scenarios for valuing start ups, do debt sizing, etc.
On the documentation side, we have chunky shareholder agreements accompanied by pages of legal jargon comprising disclaimers, indemnities and warranties.
Sometimes I feel that the complexities are there only to give bankers and lawyers a reason to exist.
And the burden of technology and excessive information at our disposal have made us so caught up in being faster and overly precise that most of us lose sight of the bigger picture.
A numbers game
"Numbers when presented and analysed in huge quantities mean something."
At every session of my Corporate Finance and Investment Banking Bootcamp class, there is almost always a newfound perspective and opinion on how we go about applying the discounted cash flow analysis to valuing businesses.
I consciously hold back diving too deep into explaining the discount rate, or the weighted average cost of capital.
“Don’t spend too much time getting the right figure”, I always said, and I sometimes question the appropriateness in my unorthodox teaching delivery.
In my humble opinion, the discount rate has always been investor driven.
Consider this:
The primary objective of trying to value any business is to arrive at a decision of to "buy" or "not to buy"
Assuming future cash flows are whatever they are, the outcome of using the NPV is solely driven by how much you want to make from the deal.
i.e. If you want a higher return, you pay a lower value, and vice versa.
If you had raised money elsewhere, then there is presumably a cost to that money, which is the cost of capital. And your appraisal of the expected return would take into account this cost, plus a premium from doing the transaction that allows you to sleep peacefully at night or even make a decent profit out of it.
That’s all there is to it, really.
There are always mis-priced deals in the real world whereby investors end up paying more than they should, and also business owners selling themselves short.
Given the relative transparency in terms of how much banks charges their clients on taking out a loan, a big part of what drives any asset pricing really comes down to the cost of equity - a mathematical estimate calculated based on something called the Capital Asset Pricing Model (CAPM).
The objective of the CAPM is to ascribe a commensurate return on equity based on the underlying risk of the asset. This is essentially driven by two things:
Establishing a baseline (equivalent to a default-free risk) and;
Adding a risk premium, which involves market volatility and taking a view of how borrowing increases risk in a business.
Since volatility in share prices results in uncertainty, and uncertainty generally equates to risk, CAPM tries to transcribe volatility to risk.
In chemistry, volatility is the tendency for something to evaporate under normal temperatures. In the finance world, volatility indicates the tendency of something to change rapidly and unpredictably, to deviate from the norm.
Hence, beta in CAPM is simply a regression analysis to understand how far a company's share price deviates from the performance of the overall market. Within the boundaries of the CAPM model, we attribute this solely to the company's leverage i.e. A firm that borrows more to fund its business is deemed to be a higher risk than its peers.

But there are so many things that can affect the share prices, and leverage is only one of them.
Furthermore, we are determining a return on equity based on a series of random events looking back over three to five years.
First there is the conventional saying of: What happens in the past does not imply that it will happen the same way in the future. Secondly: The speed at which information travels across the world and its accessibility today is very much different from what it was more than 30 years ago.
The retail and institutional investor community, which plays a huge role in influencing the movement of share prices, is also significantly larger than it was back then.
Therefore CAPM essentially is a game of numbers.
Living in an evidence-based, data-driven world, we believe that numbers, when presented and analysed in huge quantities, mean something.
To make sense of a chaotic market
"There is more art in valuation than science alone can justify."
Recently, a hedge fund manager wrote a paper about the "less efficient market hypothesis"[2], suggesting that capital markets today are not what they used to be.
A multitude of factors today influence the movement of share prices - social media apparently being one of the biggest culprits. Not to mention low interest rates encourage punters and traders to gain access to cheap financing just to take huge speculative bets on companies they have no clue about[3].
It is probably getting so difficult to make sense of the stock market even with the abundance of information. So difficult that many investors have basically given up and turned to the trillion dollar ETF market which only became popularised over the last 20 years. Funds today can simply invest into a basket of stocks and just ride the trend.
Besides, the idea of ascribing a single variable to a complex system of moving parts for valuing a business just seems absurd. Seth Klarman writes in his book "Margin of Safety":
"I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments."
Here's the interesting thing:
Establishing a discount rate using the weighted average cost of capital in deriving the fair value of an asset is mostly aimed at bridging any expectation gap between a buyer and a seller.
This is simply an attempt at using history and science to convince the other party that they are looking at things the wrong way.
In reality, a lot of deals are done based on impulse, greed, competitive tension, fear-of-missing-out, herd mentality and in some cases bad judgement.
There is more art to valuation than science alone can justify. And it doesn't get better.
The onset of COVID in 2020 had led to the emergence of meme stocks - something quite non-existent not very long ago - supported by an entire community of keyboard warriors with nothing better to do than ride on the trend of social media influencers.
“For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.” - Warren Buffett
So much for relying on math to make sensible investment decisions in a largely chaotic world.
Closing thoughts
Don't get too caught up with the discount rate when it comes to valuation.
If your objective is to impress the other party through a demonstration of knowing the inside workings of the financial markets, then go for it. But in my experience, most people sitting in this part of the world don't care much for CAPM and WACC.
The ways investors and businessmen perceive value differ across sectors and geographies.
Take for instance in China, where size is everything and winner takes it all, businesses will not think twice to burn cash through their balance sheets at the expense of grabbing market share.
Profitability without scale is useless.
But Southeast Asia can be somewhat different. The gameplay is a race for profitability - a simple function of maximising top-line and optimising expenses.
Value is created by achieving profit break-even in the shortest possible time, fixing the cost structure and searching for dislocations in prices to arbitrage the market.
Considering the difference in cultures and market dynamics across countries in this region, it is only logical and prudent that investors put more focus on earnings quality over size.
Yet, most of what we learn about finance in the comfort zone of our classrooms are originated largely from the observations and statistical findings of financial markets in the US, which operate nothing like Asia.
CAPM, for all its robust mathematical foundations, hadn't been able to capture the impact of black swan scenarios such as SARS, the 2008 financial crisis or COVID-19.
I do not discredit the theories of finance. They have been after all backed by empirical data over long periods of time.
As chaotic as the world may be, leaders of organisations cannot be seen to make decisions without relying on some form of credible evidence-based analysis.
But the rules of capitalism that work well for an efficient, mature and functioning capital market, are sometimes irrelevant in other economies where there is information asymmetry and deals are done differently.
Coming from a practitioner point of view, we should avoid being too numerically precise but instead be more commercial when it comes to valuing businesses.
Unless someone higher up or sitting at the dominant end of the negotiating table says so, valuation is always just a number.
Ultimately, it is the folks with the cash who decide what the magic number is, calibrated based on however much they want the returns to be.
Value sits with the beholder of cash in his pockets, who are you to say otherwise?
[1] DSCR = Debt service coverage ratio. Calculated as cash flows divided by debt service: a metric that measures how much cash flow buffer a company has to cover its interest and principal repayments.
[3] Check out Mark Minervini's interview on CNBC as he gets asked about the companies he invested in. Simply hilarious.