The DCF discount rate is the most important risk-representing element in the DCF methods, as it allows comparison and addition of uncertain cash flows from different points in time.
It represents the WACC (Weighted Average Cost of Capital) of a company: the fair remunerations its capital sources providers (lenders with debt, investor with common or preferred equity, etc.) should receive to fund companies with similar risk profiles.
An amount of cash now is more valuable than the same amount later. And – naturally – a sure sum is worth more than the same sum affected by uncertainty. In order to trade a future uncertain cash flow for a present certain one, a lower (i.e. discounted) equivalent must be accepted, as computed with the following formula:
Where CF0 is the riskless cash flow today, CFt the uncertain future one, DR is the discount rate, and t is the point in time (usually in years) when the cash flow will occur.
Component of the discount rate
As the version of the DCF models implemented by Equidam directly calculates the equity value of a company, the discount rate is equal to the Cost of equity. This is computed as:
- Risk free rate is the interest rate on public debt of the country where a startup is based. It is the minimum risk of any investment in that country
- β (Beta) is the company specific risk profile. It magnifies or reduces the effect of the Market Risk Premium: the higher the beta, the more uncertain the future cash flows
- Market risk premium is the country specific additional risk/return from investing in the country’s equity rather than in its lower risk public debt
On top of the resulting Cost of equity, Equidam does not follow the practice of adding further percentage points of discount when valuing young, fast growing companies. The risk elements associated with such ventures are consistently considered in the valuation through beta, survival rates, and the illiquidity discount.