When I first learned the idea of discounting cash flows at University, I always wondered how people came up with this magical discount rate.
In this article, I would like to show the general process from start to finish to come up with a somewhat accurate discount rate.

Why Do I Even Care About Discounting?

Investors can vary in their investment preferences, ranging from seeking high-growth companies and purchasing undervalued distressed businesses, to adopting a passive investment approach through index funds.
Regardless of investment style or philosophy, however, all investors abide by a fundamental principle when assessing the worth of a company:

The value of a business is the current value of the future cash flows it is expected to generate

 

This principle follows any investors:

Growth Investors

They typically seek out companies that are expected to experience rapid growth in their future cash flows. They believe that these companies will generate substantial cash flow over time, which will translate into a higher value for the business. These investors focus on evaluating the company’s growth prospects, including its competitive advantages, management team, and industry trends, to identify companies with high growth potential.

Value Investors

They perform a detailed analysis of the company’s financial statements, including its balance sheet, income statement, and cash flow statement, to determine the company’s intrinsic value. Value investors then compare this intrinsic value to the current market value of the company to identify any discrepancies. If the intrinsic value is higher than the market value, the company is considered undervalued, and the value investor may initiate a position in the company.

Passive Investors

They typically invest in index funds that track a particular market or sector. They use DCF analysis to project the future cash flows of each company in the index to determine their intrinsic value. Using these valuations, the passive investor can estimate the intrinsic value of the index fund as a whole. This approach allows passive investors to benefit from the overall performance of the market or sector while minimizing the risk of individual company-specific events.

While they all have different investment approaches, they all follow the fundamental principle that the value of a business is the present value of its cash flow.
Based on this principle, there are many questions investors may ask:

• How much Cash are they going to generate over time?
• What is the predictability of the cash flow?
• Which rate are we going to use to discount the cash flow back to its present value?
• How long is the company going to keep generating Cash?

Answering all these questions is what we investors have to do. We will use an example of a real company below to demonstrate how we can value a company using discounting the future cash flow.
But here’s the most basic but most important question you need to ask, WHAT cashflow are we using and WHY? To figure this out, we must sit back and look at the business owner’s perspective.

WHAT Cashflow

Imagine that you are an owner of a local pop-up soccer club (one of my wicked business ideas when I was 10). If you are operating any legitimate businesses, you will have to fulfill every contractual obligation before touching your hard earnt money.

As a rule of the modern world, if you have made a promise to someone, you have the duty to behave accordingly to that promise (contract) that you have made.
Simple business owners will still need to deal with a bunch of contractual obligations. If I own a local pop-up soccer club that teaches young kids how to play soccer(one of my wicked business ideas when I was 10), I have the following contractual obligations to fulfill:

• Employment contracts: paying my workers $20 each time they run the after-school squad classes for the kids.
• Venue rental agreements: I will need to rent a suitable venue for my team’s games, and I will need to sign a contract with the council. This agreement will cover things like rental fees, scheduling, and other obligations.
• League Contracts: As my team is part of a larger league, I will need to sign contracts with the league outlining my obligations and responsibilities as a team owner. These contracts will have rules and regulations and other obligations.
• Loan obligations: I’ve borrowed 100K from my wife at 4% interest repayment p.a. every quarter so I could start up a pop-up basketball club from scratch. Remember to pay her back on time, or she might bench you from the family budget.
• Concession Contracts: That’s right, I’ll need to sign contracts with vendors to sell snacks and drinks during weekend junior league games. I always make sure that I choose wisely, or I might end up with stale popcorn and flat soda. And remember to take your cut of the profits, or you’ll be left feeling like a benchwarmer on a losing team.

All the Cash left over after I fulfill all the obligations will be pocketed into my money. And I can decide what to do with that money. This is what we call the Free Cash Flow to Equity (FCFF), which is the Cash left over for equity holders in the firm. In this case, Cash was left over for me (owner of 100% of the equity) inside the basketball club’s cash drawer after we paid all the entities & people that we made a contractual agreement with.

 

As a shrewd capital allocator, I have a few options. I could choose to reinvest the money into the business, using it to improve facilities, hire more talented coaches, or increase marketing efforts to attract more kids. Or, I could retain the Cash for future uses, building up a reserve for unexpected expenses or potential future opportunities.

Of course, there’s always the tempting option of distributing the Cash to myself, but I know that this may not be the most strategic decision for the long-term health of the business. Instead, I must carefully weigh the potential benefits and risks of each option, considering factors like my competition in the local area and the needs of my young students and their parents.

My decision about what to do with the residual Cash is a clear indicator of my intentions and my view of the business’s stage of development. If I’m heavily investing back into the business, it shows that I believe the company still has significant potential for growth. On the other hand, if I decide to return all the residual Cashback to myself as personal income, it suggests that I don’t see the business as having much more room to grow. Instead, I may be using it as a “cash cow” to generate a steady stream of income while maintaining the status quo. This approach is more common in businesses that have already reached the maturity stage and are no longer experiencing rapid growth.

This brings us back to the question of WHAT Cashflow.

From the soccer school business, we learned that how we use our Free Cash Flow to Equity (FCFF) is what determines the future return of the equity holders. It’s also close to the “In-pocket” return that you are making as a business owner since you do have the right to distribute the Cash entirely to yourself. Therefore, to undertake a comprehensive valuation of a company, it is essential to consider the Future Free Cash Flow to Equity (FFCFE) as a prime determinant, which can be suitably discounted to arrive at an accurate estimate of the company’s worth.

After knowing WHAT cash flow to look for and WHY, we now need to dig in deep into HOW and WHAT measures we use to discount the future Free Cash Flow to Equity.

But even before that, I always like to ask the question, WHY.

WHY are we discounting the cash flow?

WHY Discount?

Let’s say I go to a random primary school as a business owner and somehow successfully convince the third graders to use Free Cash Flow to Equity as a metric to value a company.
And then, I give them the following data:

• I will wrap up the business in 10 years time, as I’m retiring
• I will not try to grow my business by reinvesting; I will distribute all FFCFE to myself
• The FFCFE will be $100,000 a year for the next decade.

After I presented the data, I asked all the kids to come up with a single price to buy the entire company today.

Most kids will come up with an answer close to $1 Million as a fair value. Easy right? $100,000 of annual cashflow each year for ten years, $100,000 X 10 is $1 Million!
But this simplistic approach ignores a crucial concept in finance – the time value of money. The $100,000 that we expect to receive in year ten is worth less today than it will be in 10 years due to factors such as inflation and the opportunity cost of not having that money available to us in the meantime. No one wants to give out their own liquidity for free. Why would you give million dollars to someone else to hold for ten years to get just get back the same million dollars you paid for?

By just putting the same amount into a 1.5% savings account for ten years, you could’ve made an extra $160,541!

Furthermore, how valid is my statement of “FFCFE will be $100,000 a year for the next decade” in real life? If some level of risk is associated with my soccer club business (covid lock-down etc.), we need to incorporate a risk premium into our discount rate to reflect the uncertainty of receiving those cash flows in the future.

So while it may seem easy to calculate a simple valuation based on the expected cash flows, it is important to consider the time value of money and the level of risk involved in the investment before arriving at a final valuation.

Equity is not simple as borrowing some money from a friend to buy a 6-inch meatball Subway and telling your friend that you will pay him back tomorrow. There is a certain amount required rate of return that will compensate for the hidden risk and cost that comes from leaving your money out of your hands.

Reminder, every topic of finance is controversial. There are so many different opinions and perspectives, just like those die-hard vegans, keto dieters, and masculine carnivores. But we can all agree on a few things, like the fact that inflation and interest rates are some seriously choppy waters.
Before you dive into investing your hard-earned doubloons, you need to ask yourself two crucial questions:

• Will your return on investment be enough to outpace inflation?
• Will your investment return be higher than the interest rate you’d get from a safe government bond like T-bills?

Let’s look into the inflation and T-bill rates.

The 3-month Treasury Bill rates are 4.76% as of March 6, 2023.

Ten-year Treasury Bill rates are 3.405% as of April 9, 2023.

Looking at these numbers, it is evident that as investors, we need to at least achieve a higher return than 3.405 – 6.0%. Isn’t this alarming? From this article, we saw the destructive effect that inflation has on our “in-pocket” return. Yes, this inflation rate can be “temporary”; however, if you invested in equity on February 14, 2022, and the return is below the inflation rate (6.4% p.a.), you are losing your purchasing power.

However, we will only need to take into account inflation if we are measuring the real rate of return. A nominal return is discounted by the inflation rate. If we are discounting back the future nominal cash flow, we can set the risk-free rate based on the maximum return that you can obtain free of default risk, as this will reflect the time value of money.

If you are evaluating a company based on real cash flow (cash flow after taking into account inflation), it is appropriate to use a real discount rate, which is the nominal discount rate minus the expected inflation.

If you are feeling lost, just think about the discount rate, as this

Discount Rate = Returns you can make elsewhere without risking any + Extra Risk of the Investment

When determining the risk-free rate, we are assuming that our government is the safest money borrower in the world, who would pay back the money at the pre-determined rate and time.
If you don’t believe in the government and you think the government is going to collapse soon, please let me know. But also let me know a safer borrower than the government so I can set out a new risk-free rate for myself.

Measuring the risk of the investment is much harder than estimating the risk-free rate.

When you think about risk as an investor, there is a simple question that you can ask yourself:

“Why am I risking my money in this particular project but not in the other projects that are available in the accessible universe?”

When you ask this question, the following queries may come up in your head.

• Why am I investing in this Japanese company instead of this American company that has a similar business model?
• Why am I about to put money into this particular financial service company instead of 100 other companies that are in the same industry?
• Why am I investing in a company that has a higher debt ratio when you can invest in a company that has a lower debt ratio?

And answering this question comes down to “Am I getting enough compensation for what I’m risking?”
And this “enough compensation” is called the equity risk premium. And sometimes, when the project that you invest in generates a higher return than the “enough compensation” level, the real VALUE is created.
Charlie Munger uses the horse race analogy to describe the equity risk premium.

He thinks equity markets are like a racetrack where the horses (equity) compete against each other. Just like in a horse race, there are many horses competing, and each horse has its own strengths and weaknesses.

Investors are the bettors. Everybody will come together and bet, and the odds change based on what’s bet. That’s what happens in the stock market as well. If you’re not a complete fool, anyone can see which horse is more favorable to win. Horses that have a decent track record and carry very light weight is more likely to win than a horse with a terrible record and extra weight.

But look at the odds.

The bad horse pays 100 to 1, and the good horse pays 3 to 2. Now it’s not clear which is statistically the best using simple observation.
The market is ruthless but fair in some way. If the good horse & bad horse has the same odds, the game will not work as there will be only bettors and no dumb bookies that will stake for such a game. Controversy and different opinions are the core operator in a market; as soon as everyone reaches a consensus, the market will not work. Supply and demand will simply not exist.

Therefore, the market will give a higher payoff to the bad horse, so it produces different opinions in the market.

So what we, the investors, have to do to beat the bookies will be to place our own money into projects that will produce the best risk-adjusted return. And to find the risk-adjusted return, you will need to somehow measure the risk!!

HOW to Discount?

When it came to measuring risk premiums, I was far from competent to find this by myself. There are so many factors involved in a company, and I just didn’t know how to simplify this process. So I went on and asked the Dean of Valuation: Aswath Damodaran.
He teaches corporate finance and valuation at the Stern School of Business at New York University. This guy is so good at breaking down what is considered a risk to the company. I wish I had had a professor like him to teach me corporate finance when I went to school.

He teaches a basic three-step approach to find out the equity risk premium when evaluating a company.

Find the country risk premium for your business

This is a vital part of the risk premium to measure as it reflects the geography of the business that you’re trying to value. The geographical location that the company that we’re trying to value the business in will affect the risk of the equity cash flow.

But why do people say there is a higher risk associated with investing in a foreign country? This is because the safest borrower in the country can defer. If you had to choose who to lend your money to, most people would rather lend their money to the US government than to the Ukrainian government. This is because the US government is more likely to meet its debt obligations when comparing the amount of debt relative to the income that the country is producing and other country-specific risks (etc., geopolitical risks).

As we talked about this before, if the safest borrower in your own country becomes less creditworthy, the minimum return that you will require from riskier investments will rise. Therefore, the return on equity that you will require from that country will be incrementally higher.

Out of all the metrics that measure the creditworthiness of the country, Aswath recommends students use the default spread for the country. This measures the difference in rates of two identical bonds issued in a different country.

For example, on July 1, 2022, the Brazilian government had a ten-year US dollar-denominated bond with an interest rate of 6%, while a similar ten-year US treasury bond rate was only 3.02%. The reason for the rate differences is the issuer. By measuring this “spread,” we will be able to assess the market’s assessment of default spread for Brazil. In other words, the market is placing an extra 2.98% for Brazil due to the risk of the country not meeting the debt obligation. We can use this numeric premium as a country risk premium.

Country Equity Risk Premium = Mature Market Equity Risk Premium + CDS spreads
For convenience, Aswath uses the US market as the base comparison when measuring the country’s risk premium. As above equation, the country equity risk premium will be the equity risk premium of the base country with country-specific default spread added on top of that.

You might be wondering how we measure the Mature Market Equity Risk Premium. In other words, how do we measure the excess returns over the risk-free rate that investors require for taking an extra risk on their equity investment in a mature market.?

Aswath recommends using implied equity risk premium as this will incorporate the market’s assessment of the expected return of equity. Implied equity risk premium is a product of reverse engineering. This is the general proposition:

If you know the following information, you will be able to find the rate that the market is discounting the future cashflow:

• The price paid to the asset
• Estimate of the future cashflow of the asset

Since the price paid to the asset is the present value of all future cash flow of the asset, by estimating the future cash flow of the asset, we could reverse engineer and find the implied discount rate that the market is putting onto the projected cash flow.
Aswath uses the following data to gather the information that is mentioned above:

• Price of the S&P 500 Index (used for the price paid to the asset)
• S&P 500 Quarterly Earnings and Estimate Report (used to estimate cash flows to equity)
• 10-year US Treasury bond rate (used for the risk-free rate and terminal growth rate)

Example

When you download the S&P 500 earnings data from the S&P Global website, they will give you the estimates of the aggregate dividends and buybacks that companies in the S&P 500 may payout the equity holders. You could set the long-term growth rate to the risk-free rate as an estimate.
You can create an implied risk premium calculator by completing these steps:

• Enter estimated earnings, dividends & buybacks for the next five years (2 years using the S&P global estimates and risk-free rate as a growth rate for the rest of the years)
• Compute the terminal value by using TV = FCFE / (r-g). The terminal growth rate is the risk-free rate. r can be found afterward.
• Discounting all the earnings estimate years by using a random discount rate
• Use the “Goal Seek” function (setting the present value cell to the current index price by changing the discount rate) to find the implied discount rate.
• If you subtract the risk-free rate from the implied discount rate, you now have the implied equity risk premium.

After you add whatever CDS rate on top of the implied equity risk premium, we have the country risk premium that we were looking for. By the way, if you can’t be stuffed doing all these estimations, I highly recommend going to Aswath Damodaran’s website to download the ERP Excel sheet, as he updates the implied risk premium of the S&P 500 every month.

 

Find the Business Beta

 

Many determinants influence the riskiness in businesses. As riskier businesses require a higher expected return to compensate for that risk, we will need to have a multiplier that will transform the country’s equity risk premium into a business risk premium. We call this the business beta. There are several determinants that influence business beta:

• Financial leverage: Companies with higher levels of debt tend to have higher betas, as they are more sensitive to changes in interest rates and have more financial risk.
• Operating leverage: Companies with high fixed costs tend to have higher betas, as they are more sensitive to changes in sales and have more operating risk. Businesses with higher gross margins will be less affected by inflation relative to businesses with lower gross margins.
• Growth Rate – Growth firms will have higher risk as they have to discount their cash flows for longer periods of time. As the projected period of growth is longer, the firm becomes more sensitive to economic growth risk.
• The elasticity of Demand – Companies that sell goods that are highly elastic (luxury brands) will take the hit first when the economy slows down. The earnings of companies with strong, consistent demand will be less affected by the economic slowdown.

To find the business beta that is appropriate to the company, we will need to look at other companies that have similar business models, target customers, industries, and geographical locations.
In order to find the business beta, we will need to switch our eyes and look into the public markets and find publicly traded companies that are in the same business. The screening process for this will be mainly based on industry classifications and geographic location.
Here is the step-by-step process after you gather the sample of companies:

1. Calculate the returns of each comparable company and the market index over the same period. The return is the percentage change in the stock price over a specific period. This will give you the average beta for the industry.
2. Estimate the average debt-to-equity ratio of the comparable companies. We use the market value of equity when calculating this.
3. Calculate the average unlevered beta of the comparable companies. The formula is

Unlevered Beta = Levered Beta / (1+(1-t)*D/E ratio)

1. Find the average cash % of the EV of the companies.
2. Correct the industry unlevered beta by discounting the average cash %. We do this since Cash has a beta of zero. Measuring the beta for the pure business.

Business beta = unlevered business beta/ (1- cash% of EV)

 

Finding the Bottom-up Beta for the Company

Bottom-up beta can be adjusted to reflect changes in the firm’s business mix and financial leverage. Normally, valuation experts will use a regression between stock returns against market returns. However, this is a backward-looking metric. It doesn’t incorporate the current capital structure of the business, which is essential when you are computing the risk for the future.

The cool thing with bottom-up beta is that you can have multiple of them. Microsoft is a company that has multiple business lines, such as Productivity and Business Processes, Intelligent Cloud, and personal computing. In this case, we will compute the weighted average of the different businesses to find the unlevered bottom-up beta for the company.

Finally, we can multiply the debt/equity ratio of the firm to find the levered bottom-up beta.

Levered bottom-up beta = Weighted average unlevered business beta (1+ (1-t) * (debt/market value of equity of the company))

After you compute the levered bottom-up beta for our company, we can go back to our old CAPM model and plug in the numbers to find the discount rate.

Discount Rate = Risk-free rate + (Levered Bottom-up beta * country risk premium)

The feeling of everything coming together is what I love about calculating discount rates for a company.

The risk-free rate represents the currency that we are using to value the company. If we are using the US dollar, the sum of the expected inflation of the US dollar and the expected real interest rate is the risk-free rate.
Country risk premium reflects the geography of the business.
Levered bottom-up beta can be adjected to reflect changes in the firm’s business mix and financial leverage. You can use this metric even if you don’t have the historical prices of the company that you’re trying to value!

Finding Discount Rate in Practice

Now, if we learn something, we need to put this into practice. We are going to estimate the discount rate of a real publicly listed company using the framework above.
The company that I’m going to choose is Human Creation Holdings (7361.T).

Human creation holdings is a microcap company in Japan offering IT and human resource services. It is a relatively new company that was listed on the Tokyo Stock Exchange – Growth Market Division on March 16, 2021. The company was founded in 1974.
We are not speculating on the growth of these services; we are solely using this company to explain the nature of cash flow and how we use it to analyze the company’s intrinsic value.
Ok, let’s get started.

What is the risk-free rate?

Since we are valuing this company in US dollars, we will use the ten-year US government T-bill rate, which is 3.415% as of 04/04/2023.

What is the country risk premium?

Aswath’s website publishes a monthly implied risk premium based on his S&P 500 valuation. The implied risk premium as of April 2023 is 5.37% (Trailing 12 months). This is the market consensus of how much extra discount rate will be added to future equity cash flow. However, we are valuing the equity cash flow generated in Japan. As the company only has its revenue source from Japan, we need to consider the country’s risk premium. As of January 2023, there are no CDS spread over the US CDS. The same US dollar-dominated bond issue by Japan and US is exactly the same rate. Therefore, I’m not going to include any excess premium on the discount rate. Therefore, we will land the implied risk premium in Japan at 5.37%.

What is the Business Beta?

This one is the hardest, most time-consuming, but most important one to work out on. Since Human Creation Holdings has only one revenue source, which is providing system & human resource solutions to mid-tier IT companies. What we need to do is find as many companies that will follow the following preferable criteria:

• The company is publicly listed in Japan
• A company that involves in Staffing & Employment services
• A company that is heavily associated with the IT industry.

What I usually do is go to Yahoo! Finance and focus on the “people also watch” column that shows five companies that are somewhat similar to the company that you’re looking at. I will go and check each of them carefully (sometimes it’s a completely different business) and create a list of companies. When you find the list of companies, I will go and see the total debt, Beta (5Y monthly), market cap, Cash, and EV to come up with the unlevered business beta that is corrected for Cash.
These are the companies list that I gathered which qualified the criteria (click this link for the worksheet):

Company Name	Ticker	Beta	Debt	Market Cap	Cash	EV	D/E	Cash/EV
Mirai Works Inc	6563	1.99	0	3420	532	2888	0.00%	18%
Career Co Ltd	6198	1.56	1210	2761	2229	1742.276	43.82%	128%
for Startups Inc	7089	-0.3	183.338	6395	1717.761	4860.577	2.87%	35%
Career Link Co Ltd	6070	1.24	862.434	27257	6435	21684.434	3.16%	30%
Matching Service Japan Ltd	6539	1.27	0	24014	7424.926	16589.074	0.00%	45%
Career Design Center Ltd	2410	0.8	908.337	11026	3422.206	8512.131	8.24%	40%
CRG Holdings Co Ltd	7041	1.32	509.552	3257	2015.2	1751.352	15.64%	115%
Nisso Corporation	6569	1.09	2754	23282	7933	18103	11.83%	44%
Extreme Co Ltd	6033	-0.31	195.28	7205	1670	5730.28	2.71%	29%
Technopro Holdings Inc	6028	1.42	16417	392182	42598	366001	4.19%	12%
Altech Corporation	4641	0.74	893.897	50820	9985.943	41727.954	1.76%	24%
	Median	0.98	862.43	11026.00	3422.21	8512.13	3.16%	35.34%

The law of large numbers can help calculate the business beta. The larger the sample size, the more accurate the business beta. However, it is important to ensure that the list of companies closely relates to the business being evaluated.

For instance, Yahoo Finance suggests Cookbiz Co Ltd (6558.T) as a similar business for a human resource service specializing in the food industry. While the business model of supplying specialized labor is similar, the food industry is quite different.

When gathering a list of comparable companies, the list should also reflect a sufficient sample size that can minimize the impact of outliers and provide a representative estimate for the industry beta.

Please note that the debt that I have extracted from Yahoo Finance is not the “real debt” that Aswath Damadoran advocates correcting, but for the sake of this example, I will not go further to find the correct amount of debt. I just want to show the process of what it looks like to get to the final number that we all want.

Let’s start plugging and chugging the numbers in.

We will first need to make the first adjustment by converting the median beta of the comparable companies to unlevered beta. We do this to take out the effect of the debt in the company’s capital structure. This way, we could get a better idea of the underlying risks of the business in the same industry.

The unlevered beta of all the firms will be – Median Beta of all firms / (1+(1-t) * Median D/E)
This results in a unlevered beta of 0.962

In case you were wondering why we use the tax rate in the equation, here is the explanation.

When a company takes on debt, the interest payments will become tax deductible. This lowers the effective cost of debt for the company. This tax advantage of debt is taken into account in the unlevered beta equation by using the tax rate to adjust for the tax benefit of debt financing.

We then make another adjustment by taking into account the Cash that these companies hold. Remember that the country risk premium that we calculated before already represents the systematic risk for us. We are trying to find the extra risk that the business contains. Since Cash isn’t affected by any market risk and the beta is close to zero, we will need to exclude Cash to get a beta for just the business.

To illustrate this:

Unlevered beta for firm = 0 (Cash/Firm Value) + Unlevered beta for business (1- Cash/Firm Value)

We are interested in knowing the unlevered beta for the business. Therefore, we will use this equation to find the pure business beta:

Unlevered beta for the business / (1- Cash / Firm Value)

This is an important step, especially for this valuation, since Japanese companies are known for holding large amounts of Cash on their balance sheet. In fact, the median Cash portion of all the firms on the list is 35.34%!!!

After we take out the Cash from the unlevered beta, we finally have a pure business beta of 1.488. This means that if investors are to invest in a Japanese IT human resourcing business, they will expect a return that is 48.8% higher than the equity market return, which compensates for the extra risk that they are taking.

What is the Bottom-up Beta for Human Creation Holdings Inc?

Time to focus on the company that we are actually trying to value. So what is the financial leverage that Human Creation Holding has?
Based on the December quarterly statement that they published on 10/02/2023

The highlighted part on the image above is the Cash that the company holds (Japanese is my first language) as of 31/12/2022. The amount is ¥‎780,837,000 ($ 5.908 Million USD)

On the liabilities, the company has short-term debt of ¥531,856,000 and long-term debt of ¥280,366,000, which amounts to a total debt of ¥812,222,000 ($6.146 Million USD).

The market cap of the company is ¥3.467B JPY which is around $26.23M USD.

The debt-equity ratio of the company is ¥812.222M/¥3,467M = 23.4%

We will then use this ratio to find the bottom-up beta. The bottom-up beta for the company will reflect the capital structure and operational leverage. This is the levered beta, and the calculation is down below:

Bottom-up Beta for HCH Holdings Inc = Unlevered Beta for the business * (1+ (1-t)(D/E ratio))
= 1.488 * (1+ (1-t) * (0.234)) = 1.731

This represents the excess return over the market return do Investors expect from taking the risk to invest in this single company. If the market return is 1, I expect a return that is 73.1% higher than the market for the extra risk that I’m taking.

What is the Discount Rate of Human Creation Holdings Inc?

We have calculated the bottom-up beta; now it’s time to compute the discount rate, the required rate of return that we expect from investing in Human Creation Holdings Inc.

We will plug in all the numbers that we found in this equation that was explained previously:

Discount Rate = Risk-free rate + (Levered Bottom-up beta * country risk premium)
= 3.415% + (1.731 X 5.37%) = 12.71%

Any investment opportunity in Human Creation Holdings Inc. should be evaluated against this discount rate to determine whether it is expected to generate a return in excess of this amount.

The pros will then project the future equity cash flow of the company and use this 12.71% to discount it to present cash flow to value the company.

Estimating the discount rate is typically more straightforward and has less variance. In contrast, forecasting future cash flow is associated with a significant degree of uncertainty, and small changes in assumptions or inputs can lead to large variations in the projected outcomes.

As it is evident on Twitter and other social forums, the wider difference in opinion regarding the future free cash flow for equity as compared to opinions regarding the discount rate is not surprising. Estimating the cash flow is highly subjective and uncertain.

We still have to also keep in mind that this discount rate is not static. In fact, the change in market conditions, economic trends, and other factors will influence the implied equity risk premium all the time. When you find the discount rate, it’s not the end; we will likely adjust the risk premium as the economy, and the company changes over time.

The above graph illustrates how the implied premium can change rapidly in such a short amount of time. The market is like one of your friends who changes their opinion frequently based on what they are consuming on their Snapchat feed at the time. The market is flexible and able to adjust quickly to new information and changing circumstances. However, this flexibility can also be seen as a negative trait, as the market can sometimes overreact to events, leading to excessive volatility and instability.

Conclusion

As discussed briefly at the end, the influence of your discount rate is quite small on our security valuation when compared to estimating cash flow. However, it is still very significant, and understanding the concept of opportunity cost is the core part of security analysis. I have skipped the loose ends (etc., capitalizing lease liability as debt), but again, this is an estimate. Like how finding the terms of moral justification is an unending task, adjusting the discount rate for any company or asset will also require constant updates and analysis.

Ah, isn’t this fun..