What it means
The idea rests on the time value of money. A promise of $500,000 in three years is worth less than $500,000 in your account today, because today's money could be earning a return and because a promise might not be kept.
Discounting converts that future promise into a present value so you can compare it fairly with money you hold now. The discount rate carries all the judgement.
It normally reflects what the money could earn elsewhere at similar risk, and for a company it is often the weighted average cost of capital, blending the cost of debt and the return equity holders expect. A higher rate means future cash is worth less today, so risky or distant cash flows shrink sharply.
In practice discounting is used to evaluate anything with cash flows spread over time. Net present value discounts every year of a project's cash flows back to today and subtracts the initial outlay; if the result is positive, the project earns more than the required return.
Small changes in the rate produce large changes in the answer, especially for long-dated cash flows. This is why sensible appraisal work shows a range of rates rather than a single figure, and why arguments about valuation are usually arguments about the discount rate rather than about the forecasts.
The word also has a second, unrelated meaning in trade finance, where discounting an invoice means selling it to a lender for slightly less than face value in order to receive cash immediately. The underlying logic is the same, since the lender's fee is essentially the time value of the money it advances.
In practice
Real-world examples.
Example
A logistics company weighs a $2 million warehouse automation project against five years of projected savings. Discounting those savings at 9% shows a present value below the cost, so the board asks for a cheaper phased design.
Example
An accountant valuing a small business discounts three years of forecast free cash flow plus a terminal value at 15%, reflecting the risk of a company dependent on one owner. The buyer argues for 20% and the gap in price is entirely explained by the rate.
Example
A wholesaler uses invoice discounting to release cash tied up in receivables. It sells a $180,000 invoice to a finance provider and receives most of the value immediately, paying a fee for the early access to cash.
Formula
Calculation
Present value = future value / (1 + r) to the power of n, where r is the discount rate per period and n is the number of periods
Worked example: a business is offered a payment of $500,000 in three years and uses a discount rate of 8% to reflect its cost of capital. The growth factor is 1.08 x 1.08 x 1.08 = 1.259712. The present value is $500,000 / 1.259712 = $396,916 when rounded to the nearest dollar. So the three year promise is worth about $396,916 today, meaning the business should not pay more than that for it, and the $103,084 difference is the cost of waiting.Case study
Seen in the real world.
Ambervale Renewables is a fictional developer used purely as an illustrative example. It compared two contracts: one paying $460,000 in cash on completion next month, and another paying $500,000 three years later from a well rated buyer.
Applying its 8% cost of capital, the finance team discounted the later payment to $500,000 / 1.259712 = $396,916. On that basis the immediate $460,000 was worth roughly $63,000 more in present value terms, despite the smaller headline number.
The illustrative point that stayed with the board was how sensitive the answer was to the rate. At 4% the delayed payment would have been worth about $444,000, still less than $460,000 but far closer, so the team began presenting every long-dated decision with a low, central and high discount rate rather than a single answer.
Watch out
Common mistakes.
- Confusing discounting with a price reduction, when in finance it means restating a future amount in today's money.
- Picking a discount rate by habit rather than by risk, so a speculative project is appraised at the same rate as a safe one.
- Discounting nominal cash flows with a real rate, or the reverse, which mixes inflation assumptions and distorts the answer.
Questions
People also ask.
What discount rate should a small business use?
Something close to its realistic cost of finance, often the weighted average cost of capital or the return it could earn on the next best use of the money, with a margin for risk.
Is discounting the same as depreciation?
No, depreciation spreads the cost of an asset over its useful life in the accounts, while discounting restates future cash amounts in today's terms.
Why do valuations differ so much between advisers?
Usually because they use different discount rates, since even a two point difference materially changes the present value of distant cash flows.
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