If you're an investor or watching the markets, you've probably heard of the financial term "discount rate," which is similar to the "risk-free rate."
Understanding these terms will open up a whole new world for your investments.
A discount rate is a rate of return that investors expect to exceed on an investment.
In markets, we’re always comparing the prospective rate of return against that of an investment that carries less risk. How much excess return am I getting over something safer? And is the potential reward worth the risk of paying the price?
So, what’s the bare minimum return an investor expects on any investment? That’s basically inflation. If inflation rises 2%, then in order to grow your money to maintain buying power in the economy, you need at least a 2% rate of return.
That’s why the 10-Year Treasury bond, the yield of which is considered the risk-free rate, usually yields above the rate of inflation.
In fact, say you hold the 10-Year Treasury bond at 1% interest with inflation at, say, 0.5%. For a $100 bond, divide the interest payment for the first year of $1 by 1.05%. You’d get about 95 cents.
That’s actually the present value of the future cash flow to you.
The equity, or the stock, of a company is valued by taking the sum of cash flows to the company for the next 10-plus years and then discounting all of those cash flows back to year one.
So what are we discounting by? It gets complicated—and the answer is the company’s cost of its debt and equity—but there’s one thing to remember here: the discount rate will likely move up when interest rates rise and move down when rates fall.
So when the economy is in trouble and the Federal Reserve lowers interest rates, the present value of all cash flows rises. The opportunity cost of owning those cash flows is lower. So falling rates boost stock valuations.
To see why this is crucial in today's coronavirus market, watch the quick video above.