Which discount rate to use explained – WACC vs subjective rate (10%, 15%, etc)

I do lots of valuations and often times I am being challenged that I am using a too low or too high discount rate. This is a topic that although it is not that complex, arises many discussions and I'd like to provide some insights on this dilemma and hopefully help those that are new in valuation.

Although there are plenty of discount rates to choose from, I'll focus on the WACC and the subjective rate (10%, 15%, etc.) as they are the most widely used ones.

The WACC as a discount rate attempts to assess the risk of the business through its inputs. As there is a correlation between risk and return, a company that is less risky should be expected to deliver lower returns. Is WACC perfect? No, not at all. It is backward-looking, it assumes the capital structure of a business remains the same and in some cases, it cannot even be calculated if public information is not available. However, it is the widely used model as there is no better one that captures the risk of a company. If you discount with the WACC, you'll end up with the intrinsic value of the company –> How much it is actually worth based on your assumptions about the company's future

Now, let's focus on the subjective rate. The advantage of using one is clear, it doesn't take time to calculate and it can represent your required rate of return. There's absolutely nothing wrong to use it. However, if you do, what you end up with answers the question –> How much am I willing to pay to get the return I want?

It is important not to mix the two. You shouldn't claim that a company is worth $X when you're discounting with your own required rate of return.

One of the ways to illustrate this is to take a look at something as risk-free as a treasury bond. If you want a 10% return on your portfolio and you use that to discount the bond, you'll end up with a very, very low price compared to the market price. That doesn't mean the bonds are overpriced, it's just they're offering a very low return because they have low risk. The conclusion instead would be, it is not something you should invest in to reach your investment goals.

Don't forget, sometimes there is a risk that you're discounting a very risky company with 10% that has a WACC of 15%, which could lead to looking at a company that might appear cheap to you, but isn't based on the risk it has.

Hope this helps!