Discount Rate

What is a discount rate?

Discount Rate (German: Abzinsungssatz, Diskontierungszins) denotes, in business valuation, the interest rate with which future payments are converted into their value at the valuation date. It expresses the return that capital providers require for making their capital available and for the risk they take on.

Anyone who can invest money at 10% a year turns EUR 100 into EUR 110 in one year. Conversely, EUR 110 that is only received in a year is worth just EUR 100 today at a discount rate of 10%. The higher the rate and the later the payment, the lower this present value.

Formula: Present value = future payment ÷ (1 + discount rate) to the power of the number of years until payment

Alongside the forecast, the discount rate is the most important parameter of any present value calculation. Depending on the method, it goes by a different name. In the DCF valuation, it is usually the weighted average cost of capital, a blended rate of the return requirements of owners and lenders. In the capitalised earnings method (Ertragswertverfahren), which discounts the surpluses to the owners, it is called the capitalisation rate. In the venture capital method, with which investors value young companies starting from the expected sale, it is the investor's target return. It is fixed in the valuation report, in a buyer's financial model or in a fund's investment proposal.

Outside valuation, the term has other meanings. In convertible loans, “discount” means a price reduction on conversion; in banking, discount rate denotes the interest rate at which a central bank lends money to commercial banks.

Time value and risk

Two reasons justify discounting. A euro that is available today can be invested and is therefore worth more than a euro in five years. At the same time, future payments are uncertain, and capital providers demand a premium for this uncertainty. The discount rate therefore consists of a risk-free base rate and a risk premium.

Valuation practice under IDW S 1, the valuation standard of the Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer, IDW), derives the base rate from the yields of German government bonds of different maturities at the valuation date (yield curve). The market risk premium is the excess return that investors demand for a broadly diversified shareholding in a company compared with a risk-free investment. For it, the responsible technical committee of the IDW issues recommendations in the form of ranges. Both figures change with the capital market and must be determined anew for each valuation date.

The interest rate must match the payments being discounted. This concerns maturity, risk, purchasing power (nominal cash flows with a nominal interest rate) and taxes. These equivalence principles are the yardstick by which valuers and buyers test a valuation.

Cost of equity under the CAPM

The cost of equity is commonly determined using the Capital Asset Pricing Model (CAPM).

Formula: Cost of equity = base rate + beta factor × market risk premium

The beta factor measures how strongly a company's return fluctuates with the overall market. A beta of 1 means fluctuations like the market; a beta above 1 stands for a risk above the market average.

Companies that are not listed have no share price of their own from which a beta could be read. It is therefore derived from a group of listed comparable companies, adjusted for their leverage and adapted to the capital structure of the valuation object, that is, its ratio of equity to debt capital. For smaller companies, further premiums are often discussed in practice, for example for small size or dependence on individual persons. Their derivation is contested and should be disclosed so that the other side can follow it.

Weighted average cost of capital (WACC)

The weighted average cost of capital (WACC) combines the return requirements of equity and debt capital providers. It is used to discount the free cash flows (Free Cash Flow) that belong to all capital providers jointly. The cost of debt enters after tax, because interest reduces the tax base. Weighting uses market values or a target capital structure, not book values from the balance sheet.

Formula: WACC = equity share × cost of equity + debt share × cost of debt × (1 − tax rate)

Many technology companies have little debt or hold more liquid funds than financial debt. Their weighted average cost of capital then corresponds largely to their cost of equity. Conversely, higher debt financing does not lower the weighted average cost of capital indefinitely, because with leverage the risk, and thus the owners' return requirement, also rises.

Target returns of venture investors

Investors in young companies, for example venture capital funds, rarely work with cost of capital under the CAPM but with target returns. As a rule of thumb, target returns of 40% or more per year are cited for early stages, and rather 20 to 35% for later growth rounds such as Series B or Series C. The values depend on the fund, the market and the individual case.

The level is not explained by the risk of the individual company alone. The target return is applied to the success case of the plan and must therefore also compensate for the holdings that fail. In addition there are the lack of tradability of the shares, the long holding period and the costs of the fund. With increasing maturity, default risk and target return fall. For founders, the connection is of practical importance: through the expected exit multiple, the target return determines the share that an investor demands for its capital.

Worked example: calculating and applying the discount rate as WACC

The weighted average cost of capital is derived for a software company. The assumptions are hypothetical: risk-free rate 3.0%, market risk premium 6.0%, beta factor of the comparison group after adjustment to the capital structure 1.5, cost of debt 6.0%. For simplicity, the tax rate used is the total burden of 30% from corporation tax, solidarity surcharge and trade tax (as of 2026). The restricted deductibility of interest for trade tax is disregarded. The reduction of corporation tax decided from 2028, down to 10% in 2032, would reduce the tax advantage of interest and slightly raise the cost of debt after tax.

• Cost of equity: 3.0% + 1.5 × 6.0% = 3.0% + 9.0% = 12.0%
• Cost of debt after tax: 6.0% × (1 minus 0.30) = 4.2%
• Capital structure at market values: 75% equity, 25% debt
• Weighted average cost of capital: 0.75 × 12.0% + 0.25 × 4.2% = 9.0% + 1.05% = 10.05%, rounded 10%

In the second step, a payment of EUR 10 million expected in five years is discounted at three rates. The discount factor is in each case 1 divided by (1 + interest rate)⁵.

• At 10%: 1.10⁵ = 1.6105; factor 0.6209; present value EUR 6.21 million
• At 25%: 1.25⁵ = 3.0518; factor 0.3277; present value EUR 3.28 million
• At 40%: 1.40⁵ = 5.3782; factor 0.1859; present value EUR 1.86 million
• Read the other way round: a target return of 40% over five years requires 5.38 times the capital invested

From the point of view of an investor with a 40% target return, the same amount is worth less than a third of what a buyer with a cost of capital of 10% assumes. This is why valuations of the same company by a strategic acquirer and by a venture investor can differ so widely without either side miscalculating.

Distinctions: discount rate, capitalisation rate and internal rate of return

• Capitalisation rate: the term of the capitalised earnings method for the owners' discount rate. In the perpetuity, it is reduced by a growth discount.
• Internal rate of return (IRR): the return at which the net present value of an investment is zero. It describes an achieved or expected return, the discount rate a required one. The net present value (NPV) is the sum of the payments discounted at the discount rate less the initial investment.
• Valuation discounts: discounts for lack of tradability or a minority position are applied to the value, not to the interest rate. Anyone who also captures them in the interest rate counts them twice.

Common mistakes

• Interest rate does not match the cash flow. Free cash flows to all capital providers belong discounted at the weighted average cost of capital, payments to the owners at the cost of equity. Mixing them distorts the result.
• Beta without adjustment. The beta of a comparison group reflects its leverage. Without adjustment and adaptation to the company's own capital structure, it is not transferable.
• Book values as weights. The balance sheet equity of successful companies is usually far below its market value. Weighting with book values overstates the share of the cheaper debt capital.
• Blanket premiums without justification. A premium of a few percentage points “for risk” cannot be verified and is the first thing the other side attacks in negotiations.
• Target return applied to a cautious plan. Venture target returns are intended for the success case. Applied to a plan that has already been set cautiously, they capture the risk twice.

Frequently asked questions

How strongly does one percentage point more of discount rate act?

That depends on how far in the future the payments lie. A payment in five years loses about 4.4% of its present value at 11% instead of 10%. For a perpetuity with 2% growth, the value falls from 12.5 to 11.1 annual amounts, that is, by about 11%. The larger the share of the terminal value, the more strongly the valuation reacts.

Where does the beta factor of an unlisted company come from?

From a group of listed comparable companies with a similar business model. Their beta factors are adjusted for leverage, aggregated and adapted to the capital structure of the company being valued. The selection of the comparison group is therefore one of the most important individual decisions in the valuation.

How is the discount rate calculated?

Usually as the weighted average cost of capital. First the cost of equity is determined under the CAPM, then the cost of debt after tax, and both are weighted by market values or target capital structure. Venture investors apply their target return instead; in the capitalised earnings method, the owners' capitalisation rate is used.

Is the discount rate the same as the discount on a convertible loan?

No. The discount on a convertible loan is a reduction on the share price on conversion, for example 20% below the price of the funding round. It is often combined with a valuation cap (Valuation Cap). The discount rate in valuation is an interest rate per year at which future payments are discounted.

Which discount rate applies to tax valuations?

That depends on the method. The simplified capitalised earnings method of the German Valuation Act (Bewertungsgesetz) works with a capitalisation factor fixed by law rather than with an individually derived interest rate. For other recognised methods, the rate is derived as in general business valuation.

The Roemer Capital view

In a company sale, Roemer Capital examines the cost of capital with which buyers calculate, item by item: comparison group, beta factor, premiums. An unjustified premium of two percentage points can change the value more than many individual items of the plan, and it can be challenged with figures.

In funding rounds, Roemer Capital translates the investors' target return into its consequences for the founders. These are the required value at exit and the share that an investor demands for its capital. Anyone who knows this calculation before the first conversation understands why investors with a similar plan arrive at different valuations.