What the discount rate does in a DCF
A DCF adds up a company's future free cash flows after shrinking each one for the time until it arrives and the risk that it does not. The discount rate is the shrink factor, and it is the return you require for tying your money up in this business rather than in something safer. Small changes in it have large effects because it compounds over every year of the forecast and sets the terminal value. On the illustrative company in the DCF model example, the value per share is $47.57 at an 8% discount rate, $39.26 at 9% and $33.18 at 10%. No other single assumption moves the answer that much, which is why the rate deserves a deliberate choice rather than a default.
The WACC formula
WACC = E ÷ (D + E) × Re + D ÷ (D + E) × Rd × (1 − t)
where E is the market value of equity, D the market value of debt, Re the cost of equity, Rd the pre-tax cost of debt and t the tax rate. The idea is that a company's capital comes from two groups with different required returns, and the business must earn at least the blended figure to satisfy both. Interest is tax-deductible, which is why the debt leg is multiplied by (1 − t).
Use market values for the weights, not book values. Book equity is an accounting residual that buybacks and write-downs can shrink to almost nothing; market capitalisation is what shareholders actually have at stake. Debt is usually close enough to book value unless the bonds trade far from par.
Cost of equity: CAPM and its limits
Re = risk-free rate + beta × equity risk premium
The capital asset pricing model starts from the yield on a long government bond, then adds a premium for owning equities, scaled by beta, the stock's sensitivity to the market. With a 4.0% risk-free rate, a beta of 1.1 and a 5.0% equity risk premium, the cost of equity is 4.0% + 1.1 × 5.0% = 9.5%.
Each input is debatable. Beta is estimated from past price moves and can shift a lot depending on the window and the index used; it also measures volatility rather than the risk of permanent loss. The equity risk premium is an assumption about the future, commonly placed somewhere between 4% and 6%. For these reasons many practitioners treat CAPM as a starting point and then adjust: a little higher for small or thinly traded companies, for heavy leverage or for a business whose cash flows are unusually hard to forecast. The adjustment should be stated, not hidden in a tweaked beta.
Cost of debt, after tax
The cost of debt is what the company would pay to borrow today, not what it paid years ago. The best source is the yield on its traded bonds; failing that, interest expense divided by average debt is a reasonable proxy, and the debt footnote in the 10-K lists the rate on each facility. Because interest reduces taxable income, the cost that matters to shareholders is after tax: at a 5.0% borrowing rate and a 25% tax rate, 5.0% × (1 − 0.25) = 3.75%. Lease liabilities are debt for this purpose and carry a similar implied rate.
Worked example (illustrative)
Harbor Foods, the fictional company from the DCF example, has 50 million shares at $30, so its equity is worth $1,500 million. It carries $300 million of debt and $100 million of cash. Weights use gross debt, because that is what lenders are owed:
| Piece | Value | Weight | Cost | Contribution |
|---|---|---|---|---|
| Equity | $1,500m | 83.3% | 9.5% | 7.92% |
| Debt | $300m | 16.7% | 3.75% after tax | 0.63% |
| WACC | $1,800m | 100% | 8.54% |
The DCF example used 9%, a little above the computed figure. That is a reasonable habit: rounding the rate up for the uncertainty in beta and the premium costs little and keeps the valuation conservative. What would not be reasonable is rounding it down to make the stock look cheaper, which is the most common way a DCF is quietly bent toward the answer its author wanted. The stock valuation calculator shows the value at each rate side by side, so the choice is visible.
When a hurdle rate is the better choice
Many experienced investors do not compute a WACC at all. They discount every company at a fixed hurdle rate, perhaps 8–10% for large, stable businesses and more for smaller or riskier ones, and put the company-specific caution into the cash-flow forecast and the margin of safety instead. The argument is that CAPM's inputs are too uncertain to justify three decimal places, and that a consistent rate makes companies comparable: if every stock is valued at 9%, the ranking is honest even if the level is debatable.
Whichever you use, match the rate to the cash flow. WACC discounts free cash flow to the firm, before interest, and the result is an enterprise value from which debt is subtracted. A cost of equity on its own discounts free cash flow to equity, after interest and debt repayments, and the result is already the equity value. Mixing them, most often by discounting firm cash flow at the cost of equity, understates the value of any company with debt. The stock valuation guide lays out both routes.
Common mistakes
- Book weights. Using book equity instead of market capitalisation can double the debt weight and produce a WACC far too low.
- Cheaper debt, cheaper WACC. Adding debt appears to lower WACC because debt is cheaper than equity, but leverage raises the cost of equity as shareholders bear more risk. Beyond a modest level the blended rate stops falling and the risk of distress rises.
- A units slip. Adding a cost of equity in percent (9.5) to a cost of debt expressed as a fraction (0.0375) makes the debt leg vanish. It is an easy error in a spreadsheet and it survives because the answer still looks plausible; check that both legs are in the same units.
- Terminal growth at or above the rate. The terminal value divides by (rate − growth), so growth must be below the rate, and well below it to be sensible: a company cannot grow faster than the economy forever.
- A rate per answer. Choosing 7% for the stock you like and 11% for the one you do not is not analysis. Pick a method, write it down, and apply it everywhere.
The intrinsic value article shows what each of these choices does to the final number on the same example company.
See the value at every rate
The free DCF calculator shows the value per share at your discount rate and at a point either side, so the choice is visible rather than buried.
Frequently asked questions
What is a typical WACC?
For large, established companies in developed markets a WACC between roughly 6% and 10% is common, with the level depending on interest rates at the time, the company's leverage and how risky its business is. Smaller, more volatile or more indebted companies warrant more. The exact figure matters less than applying a consistent method across the companies you compare.
Should I use WACC or the cost of equity as my discount rate?
It depends on the cash flow. Free cash flow to the firm, before interest, is discounted at WACC and gives an enterprise value; subtract net debt to reach equity. Free cash flow to equity, after interest and debt flows, is discounted at the cost of equity and gives the equity value directly. Using the cost of equity on firm cash flow understates the value of any company that carries debt.
What beta should I use in the cost of equity?
A beta estimated over several years against a broad index is the usual starting point, but estimates vary with the window and the index, and beta measures price volatility rather than the risk of losing money permanently. Many investors cap it within a sensible range, or set the cost of equity directly from judgment, and state the adjustment rather than tuning beta until the answer looks right.
Is a higher discount rate more conservative?
Yes, in that it lowers the value and so demands a lower price. But piling caution into the discount rate and then also forecasting pessimistic cash flows and demanding a large margin of safety can mean never buying anything. Decide where the caution lives, apply it once, and keep the rate consistent across companies.
Why must terminal growth be lower than the discount rate?
The terminal value formula divides the final cash flow by (discount rate − terminal growth). As growth approaches the rate the value heads toward infinity, and above it the formula gives a negative, meaningless number. Economically, no company can outgrow the whole economy forever, so terminal growth is usually set near or below long-run nominal GDP growth, well under the discount rate.