A discount rate is the percentage by which the value of a cash flow in a discounted cash flow (DCF) valuation is reduced for each time period by which it is removed from the present.
The estimation of a suitable discount rate is often the most difficult and uncertain part of a DCF. This is only worsened by the fact that the final result is very sensitive to the choice of discount rate — a small change in the discount rate causes a large change in the value.
Cash flows other than listed securities
For unlisted securities and for other types of streams of cash flows it becomes a little more difficult. If listed securities exist that are similar in terms of undiversifiable risk, then these can be used as benchmarks to estimate what the appropriate discount rate should be.
A comparatively simple approach is to find a pure play company in as similar a business as possible and calculate its WACC. This may be the appropriate discount rate, or it may need further adjustment. If further adjustments are needed it is usually best to work from the WACC, using the CAPM, to calculate what the beta would be given only equity funding, and adjust the beta. This is correct because of capital structure irrelevance.
Sometimes it is possible to make simple adjustments. For example, if the cash flows face a similar (undiversifiable component of) revenue volatility to the benchmark, but a different level of operational gearing, simply multiply the beta by the ratio of (1 + fixed costs as a percentage of revenues) for the cash flows being evaluated to the same for the benchmark.
In many cases it will be necessary to use detailed modelling to estimate the difference in the sensitivity to undiversifiable elements. In practice this means modelling the relationship between economic growth (the economy is the main undiversifiable risk) and both sets of cash flows. It may be simpler to use the market as the benchmark, in which case the ratio is the beta.
In many, if not most, cases in developed countries, it is possible to find a good enough pure play comparator and avoid the complex approach.
In all cases, especially the last, it is useful to calculate a DCF with several different discount rates, so that the sensitivity of the final result to this assumption can be clearly seen.