The discount rate represents the rate by which money earned or held in the future is less valuable than money held today. For example, if someone offers you $100 today, or $100 ten years from now, every reasonable person would choose the first option. After all, you could always just choose the $100 today and hold the money under your mattress and be at least as well off as if you chose option two. The “discount rate” generally then reflects the opportunity costs for holding the money. If you can buy a ten-year Treasury bond (which are generally considered risk-less) with a positive interest rate, then you would have to be offered at least as much ten years from now than you could get from buying the Treasury bond.
Several different factors affect the discount rate:
The strength of the economy. When the economy is hot, the value of money today rises. After all, if the equities are returning 15% annually, it’s a lot more valuable to have money you can invest today than if equities are returning 2% annually.
Personal liquidity concerns. Discount rates are not uniform across all actors. If you need to scrape together enough money to make rent, then a dollar today is worth a lot more than a dollar after rent is due. In contrast, for a mature company or government with low solvency risk, then the discount rate might be much lower.
The discount rate is a major input into equity pricing. In one simplified model, an equity’s price should be equal to the discounted present value of future dividends. Let’s break that down term-by-term. A dividend is a payment made by a company to its equity holders. The discounted present value is the process of applying that discount rate to money earned in the future to put it all in terms of “today’s dollars”. In the following example, assume the annual discount rate is 2%. A company that will pay out exactly $300 today to its equity holders then dissolve into nothing will have equity that is worth, in total, exactly $300. In contrast, a company that will $100 today, $100 a year from now and $100 two years from now. That company will have its equity worth $100 + $98 + $96.04 = $294.04.