INVESTMENT EXPLAINED: What you need to know about the discount rate – nothing to do with sales and a term that has two different meanings
In this series, we break down the jargon and explain a popular investing term or topic. Here is the discount rate.
Something to do with sales?
No – and, confusingly, the term has two distinct meanings.
The first of these is the interest rate that the Federal Reserve, the US central bank – known as the Fed – charges banks for loans when they need a back-up source of funding.
The right way ? : The system has its detractors and it is not a crystal ball but rather a guide: the goal is to make an informed decision
The second meaning is an element of an analysis intended to show the viability of an investment. It is used by companies that are planning to initiate a takeover of another company or decide to commit capital to a project.
In such cases, the discount rate is sometimes referred to as the “hurdle” rate.
Tell me more about the Fed rate
Loans from the Fed to banks are generally issued overnight, but this period – the window – can be extended in emergencies, such as during the 2008-09 global financial crisis.
Such was the need for these funds that in October 2008, just after the collapse of Lehman Brothers, discount rate borrowing reached $404 billion from a monthly average of $0.7 billion since 1959.
Why has the US bank rate increased?
Currently the discount rate is 1%; a year ago it was 0.25%.
The rate, which is set by the Fed’s Board of Governors, is one of the mechanisms the central bank uses to control the money supply and therefore inflation, a priority at present. Jerome Powell, the chairman of the Fed, told the American people: “Inflation is way too high and we understand the difficulties it is causing. We move quickly to bring it back down.
What about the second meaning?
Discount rate is used in DCF – discounted cash flow analysis.
DCF, calculated in a complex formula, is a way to determine if an investment is worth its current cost by analyzing its future earnings.
The calculation uses a discount rate, which is the return you want to achieve. it helps you determine the maximum you are willing to pay today for a return at some point in the future, taking into account the risks involved.
Many stock market analysts rely on the DCf, trying to figure out what future cash flows will be, when looking at companies’ accounts to determine if their stocks are worth buying today.
Is this a reliable way to choose an investment?
The system has its detractors.
It is not a crystal ball, but rather a guide: the goal is to make an informed decision.
If you can make an investment at less than the sum of the discounted cash flows, the investment may be undervalued, with significant potential for recovery.
If the cost is higher than these cash flows, the investment could be overvalued.
Of course, there are no guarantees.