Estimating discount rates under DCF exercise

The estimation of a discount rate while trying to arrive at the intrinsic value of an entity is a tricky affair. Wrong estimation of discount rates can result in sub optimal and misleading valuations that may disrupt informed investment decisions.

Instead of using complex formulas and equations to arrive at discount rates, lay investors can use simple arithmetics and a clear understanding of EIC (Economy-Industry- Company) picture to arrive at the appropriate cost of capital. Investors may take into account the following factors in estimating discount rates namely:

1. The risk free rate as indicated by Treasury bills issued by RBI. These are
typical government bonds whereby payment of interest and repayment of capital are
near certainity and thereby carry little or neggligible risk.

2. To this risk free rate, we add risk premium based on the level of industry risk,
political risk, business risk, financial risk and other exclusive/selective risk
factors surrounding the company under valuation exercise.

3. Companies of smaller size have higher share of risk compared to large sized
companies that have much more diversified business streams.

4. Companies in cyclical industries like steel, sugar or cement have higher risk
attached to them when compared to companies in defensive segments with stable
cash flows like FMCG or healthcare. Therefore cyclical companies will have higher
discount factor.

5. Other factors u may consider while incorporating discount rates are management
quality, corporate governance, Accounting quality etc

For every factor that u feel necessitates a higher risk portion, u should appropriately increase the discount rate.