In finance, the discount rate has two important definitions. First, a discount rate is a part of the calculation of present value when doing a discounted cash flow analysis, and second, the discount rate is the interest rate the Federal Reserve charges on loans given to banks through the Fed's discount window loan process.
Discounted cash flow, uncertainty, and the time value of money
The first definition of the discount rate is a critical component of the discounted cash flow calculation, an equation that determines how much a series of future cash flows is worth as a single lump sum value today. For investors, this calculation can be a powerful tool for valuing businesses or other investments with predictable profits and cash flow.
For example, let's say a company has been in business for over 100 years, has considerable and consistent market share in its industry, and while consistently profitable, doesn't have the opportunity for significant growth. The company is stable, consistent, and predictable. This company, similar to many blue chip stocks, is a prime candidate for a discounted cash flow analysis.
If we can forecast the company's earnings out into the future, we can use the discounted cash flow to estimate what that company's valuation should be today. Unfortunately, this process is not as simple as just adding up the cash flow numbers and coming to a value. That's where the discount rate comes into the picture.
Cash flow tomorrow is not worth as much as it is today. We can thank inflation for that truth. As prices rise over time, a dollar won't buy as much stuff in the future compared to what it can buy today. Second, there's uncertainty in any projection of the future. We just don't know what will happen, including an unforeseen decrease in a company's earnings. Cash today has no such uncertainty; it is what it is. Because cash flow in the future carries a risk that cash today does not, we must discount future cash flow to compensate us for the risk we take in waiting to receive it.
These two factors -- the time value of money and uncertainty risk -- combine to form the theoretical basis for the discount rate. A higher discount rate implies greater uncertainty, the lower the present value of our future cash flow.
Calculating what discount rate to use in your discounted cash flow calculation is no easy choice. It's as much art as it is science. The weighted average cost of capital is one of the better concrete methods and a great place to start, but even that won't give you the perfect discount rate for every situation.
Understanding that our discount rate is an educated guess and not a scientific certainty, we can still move forward with the calculation and obtain an estimate of this company's value. If our analysis estimates that the company is worth more than the stock currently trades, that means the stock could be undervalued and worth buying. If our estimation shows the stock is worth less than its stock currently trades, then it may be overvalued and a bad value investment.
The Federal Reserve's discount window
The other important definition of the discount rate is the interest rate charged to financial institutions when they borrow money from the Federal Reserve's discount window lending facility.
The discount window allows banks to borrow money for very short term operating needs. These loans are typically extended for 24 hours or less. The interest rate charged is determined individually by each of the Federal Reserve banks, but is centrally reviewed and determined by the Board of Governors of the Federal Reserve System. Generally, the discount rate will be the same across all the Federal Reserve Banks, except for the days around the time the discount rate changes.
The discount window actually offers three different loan programs, each with its own discount rate. The primary credit program is the Fed's main lending program for eligible banks in "generally sound financial condition." The discount rate on these loans is typically set above the existing market interest rates available from other sources of short term or overnight debt.
The secondary credit program is available to financial institutions that are not eligible for the primary credit program, but still require short term loans to fund short term needs or to resolve severe financial difficulty. Loans from the secondary credit program carry a higher discount rate than loans in the primary credit program.
The third program is the seasonal credit program, available to smaller financial institutions with recurring fluctuations in their cash flow. A common example are agriculture banks, whose loan and deposit balances fluctuate each year with the various growing seasons. The discount rate on these loans is determined from an average of selected market rates of comparable alternative lending facilities.
If you're here because you're looking to learn more about stocks, head to our Broker Center, where we can help you get started.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!