What is Discounting?
Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future.
Given the time value of money, a dollar is worth more today than it would be worth tomorrow. Discounting is the primary factor used in pricing a stream of tomorrow’s cash flows.
introduction of Discounting
When it comes to business ventures and investments, assets are considered to not carry value unless they come with cash flow generation potential. It means that they can produce cash flows that allow the business owner or investor a return.
Examples of such cash flows can be interest received from a bond or fixed-term deposit, or dividends received from a stock. The future cash flows’ present value is obtained by using a discount rate or factor and applying it to the cash flows.
How Discounting Works
For example, the coupon payments found in a regular bond are discounted by a certain interest rate and added together with the discounted par value to determine the bond’s current value.
From a business perspective, an asset has no value unless it can produce cash flows in the future. Stocks pay dividends. Bonds pay interest, and projects provide investors with incremental future cash flows. The value of those future cash flows in today’s terms is calculated by applying a discount factor to future cash flows.
Discounting and Risk
In general, a higher the discount means that there is a greater the level of risk associated with an investment and its future cash flows. Discounting is the primary factor used in pricing a stream of tomorrow’s cash flows.
For example, the cash flows of company earnings are discounted back at the cost of capital in the discounted cash flows model. In other words, future cash flows are discounted back at a rate equal to the cost of obtaining the funds required to finance the cash flows. A higher interest rate paid on debt also equates with a higher level of risk, which generates a higher discount and lowers the present value of the bond.
Indeed, junk bonds are sold at a deep discount. Likewise, a higher the level of risk associated with a particular stock, represented as beta in the capital asset pricing model, means a higher discount, which lowers the present value of the stock.