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The discount rate is the answer to the question, how much more is a dollar today worth than a dollar later? The answer depends on how much your dollar today would grow if you invested it. The rate that it would grow depends on interest rates and whether you would invest it in safe bonds or riskier stocks; plenty of even riskier investments exist as well. Everybody has their own unique discount rate depending on how they invest and use their money. Let’s use 6% per year for now.
If you invested $1.00 today and it grew at 6% per year, you would have $1.06 in one year. In the same way, if you had $0.94 today, you would have $1.00 after growing it at 6% for one year. This means that if your discount rate is 6%, one dollar next year is worth $0.94 in today’s dollars.
The higher your discount rate, the less one dollar next year is worth to you. For example, if your discount rate is 10%, then one dollar next year is worth $0.91 today.
Another way of thinking about this is, if someone offers you something that generates one dollar next year and your discount rate is 6%, you should only pay $0.94 for it today. If they wanted to charge you $0.95, you would be better off investing that money at 6% instead of buying their device, because you would have $1.01 in one year.
Every year that goes by, the annual discount rate is applied again, just like an interest rate would be. One dollar invested today grows at 6% to $1.06 next year, $1.12 in the second year, $1.19 in the third, and so forth.
Three good benchmarks to keep in mind are treasury bills, bonds, and stocks. Everybody has their own discount rate. People who would invest in very safe things – for instance, a retired person who needs a guaranteed cash flow – use low discount rates because the safe investments they tend to make have low rates of return. It’s appropriate to use a higher discount rate for riskier investments, since in the market, high risk is associated with high potential gains.
Three good benchmarks to keep in mind are treasury bills, bonds, and stocks. Treasury bills are backed by the US government and are considered the ultimate safe investment. Bonds are less safe, and stocks are the most risky. Broadly, treasuries tend to return around 3%, bonds around 6%, and stocks around 10%, in pre-tax terms. These numbers change from year to year, especially the riskier investments.
Most investment returns are reported in pre-tax terms, meaning that if we say stocks return 10% per year, that means that the actual value of the stocks themselves increased by 10%. However, it’s important to remember that we receive the value of investments in after tax dollars. So if we invest $100 at 8% and end up with $108, we will pay taxes on the $8 that were created.
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