What Is Stock Discounting?
Whether investing in real estate, private corporations or the stock market, a person likes to be able to keep track of the position of his investment at any time. The calculation of discounting lets the investor determine the present value of future money by calculating the cost of capital. Discounting also allows an investor to determine if the price of a stock and its return is suitable for his investment range.
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Importance
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Discounting allows you to calculate and compare the position of your investment at any point in time. As an investor in property, for example, you are discounting when you calculate the total payments you can expect to receive by a certain date prior to the final payment. In similar fashion, the price you pay for a stock should be based on the amount of dividends you can expect to receive indefinitely. If there are no dividends, however, you would pay a price equal to the discounted value you can expect to receive if you were to sell the stock.
Return
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Before you invest in stock, you should have an idea of what you are expecting the company to give you annually. If you are expecting the company to give you 15 percent per year for a return of $75 per share, you cannot pay more than $75 per share. The share price must be discounted to ensure your expected return. If it isn't lowered enough to meet your expected return, it may not be the investment of your choice.
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Appropriate Discount
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The discounting of future dividends and stock prices depends on time and money. It involves the estimated future interest rates, dividend policies and other variables that may affect the stock. An appropriate discount rate can be hard to determine. As low as 3 percent can yield a high valuation, while 25 percent can be overvalued. In part it is your preference. Warren Buffet's recommendation for the right discount is to apply the same amount of discount earnings as long-term Treasury bonds.
Value
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Imagine the offer to purchase a genie in a bottle who will satisfy all your desires on the condition that you sell it for less than you bought it for when you are done with it. You can't buy it for one cent because you can't sell it for less. You wouldn't buy it for two cents because the person buying it from you for one cent wouldn't be able to sell it. This applies to any price if the bottle is to be sold in the near future. You might be inclined to buy it for $1,000 because the bottle can go a long way before its resale is halted. Long-term stock, compared to short-term stock, tends to increase in value with steep discounting.
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