Sometimes it's just good to channel Maria in the Sound of Music and go back to basics. I recently had a good opportunity to do this as one of the key sources of valuation information, the "Ibbotson Valuation Yearbook" was reformatted as a result of the transfer of publishing rights and became the "Duff & Phelps Valuation Handbook". (The volume actually measures 11" X 9" so to call it a "Handbook" is a bit of a stretch. Though only a pedant would quibble on this point. Which I am not. So I won't). This annual publication provides information on components of the discount rate to be applied when we use the income method of valuation to convert a series of projected future cash flows into a present value.
The introduction to the new Handbook provides a number of ways of thinking about the discount rate (or the "cost of capital" as it is also known). Shannon Pratt and Roger Grabowski, two valuation gurus, define the cost of capital as "the expected rate of return that the market requires in order to attract funds to a particular investment". The Handbook alternatively states it is "the expected return appropriate for the expected level of risk". This perspective combines the concepts of both risk and return. Generally, the higher the risk, the higher the expected return.
The discount rate can be thought of from the perspective of an investor with a range of potential investments - each investment promises a series of future cash flows. The greater the risk that the actual cash flows will differ from the promised cash flows, the higher the level of return the investor will demand.
Assume an investor has $1,000 to invest and two potential investments; investment A is to lend the money to Dominion Power. Investment B is to lend the money to NewCo that is in the early stages of developing a cure for cancer but has not yet received FDA approval. In each case, the loan will be for two years and the companies agree to pay back the loan at the end of that time plus interest. In the case of investment A, the investor can be fairly certain Dominion Power will be around to pay off its debt in two years. The same cannot be said for investment B - there is a significant chance that NewCo will fail well before the expiry of two years and the loan may never be repaid. As a result, the investor will demand a higher interest rate on the loan to NewCo than Dominion Power since there is much greater risk in the investment. The interest rate demanded by the investor is "the rate of return required to attract funds to that investment". If the interest rate is not high enough, NewCo will not be able to raise funds. The interest rate demanded by the investor is in effect the cost of capital.
So much for the primer. And now, if you'll excuse me, I have to don my lederhosen and get back to singing practice.