Every discounted cash flow on this site uses a 9% discount rate, and every one of them says so in a small line under the results. That line is doing more work than any other number in the calculation. Move the discount rate by one point and Stetron's fair value moves by more than moving its growth assumption by one point -- and the discount rate is also the input people are most tempted to type in from habit, because "nine percent" or "ten percent" sounds like something everyone uses.
It is not a convention. It is a claim about what the capital funding this specific business requires to be paid, and it can be built from parts you can source and defend. This guide builds Stetron's 9% from those parts. The same assembly works for any company whose inputs you can estimate.
What the number is doing
A discount rate is a required return. Stetron is funded by two groups of people who each want something different: lenders, who contract for interest and get paid first; and shareholders, who get whatever is left and bear most of the risk. The discount rate blends what each group requires, weighted by how much of the capital each group supplies.
That is also why it is called a weighted average cost of capital. It is not one investor's required return -- it is the blended price of all the capital in the structure. Discounting Stetron's free cash flow at this blended rate produces an enterprise value, which is why the DCF then has to subtract the $200m of net debt before dividing by shares. The rate and the subtraction are two halves of the same idea: lenders' claims are priced into the rate, so they have to be removed from the output.
The formula, one term at a time
Written out:
WACC = (E/V) × Re + (D/V) × Rd × (1 − t)
Five inputs, each of which is a separate decision. Here they are with the values this guide will defend for Stetron:
| Input | Meaning | Stetron value |
|---|---|---|
| E | Market value of equity | $1,880m (50m shares × $37.60) |
| D | Market value of debt | $340m ($80m short-term + $260m long-term) |
| Re | Cost of equity | 9.8% (built below) |
| Rd | Pre-tax cost of debt | 5.8% (built below) |
| t | Statutory tax rate | 21% |
Two of the five -- Re and Rd -- are estimates. The other three are facts you can look up, though one of them (the market value of equity) has a trap in it that most tutorials skip.
Cost of equity: the CAPM build
Equity has no contract, so its required return has to be estimated. The standard tool is CAPM: the risk-free rate, plus a premium for bearing market risk, scaled by how much market risk this particular share carries.
- Risk-free rate: 4.3%. The yield on the 10-year Treasury, because Stetron's cash flows are projected in dollars over a horizon comparable to ten years. The rate should match the currency and the duration of what you are discounting.
- Beta: 1.1. Stetron is a mid-cap industrial with cyclical sales, so its share moves somewhat more than the index. A regression against a broad index over at least two years, ideally five, lands here. Published betas vary enormously between data providers for the same company -- small sample, different indices, different adjustment methods -- so note your source and its window.
- Equity risk premium: 5.0%. The compensation for holding equities instead of the risk-free asset. Practitioners genuinely disagree here, using anything from 4% to 6% for developed markets. Stetron uses 5%, the middle of the defensible range.
Put together: 4.3% + 1.1 × 5.0% = 9.8%. That is the return a Stetron shareholder requires. It is noticeably higher than the risk-free rate because a cyclical industrial is not risk-free, and the 1.1 beta says exactly how much riskier than average it is.
Cost of debt: yesterday's rate versus today's
Debt is easier because it is contractual -- but there are still two candidates, and choosing the wrong one is common.
The historical implied rate comes from Stetron's income statement: interest expense of $22m against $340m of total debt works out to 6.5%. That is the average rate on borrowings the company took on in the past, at past spreads, in past rate environments.
The marginal rate is what Stetron would pay if it walked into a bank today. For a company of this size and credit quality, in the current environment, that is about 5.8%. The discount rate is supposed to price the capital the business will use going forward, not the capital it happened to raise years ago -- so the guide uses 5.8%, and the DCF inputs across this site do the same. When the two rates are close the choice hardly matters; when rates have moved sharply, using the historical average silently bakes yesterday's environment into tomorrow's valuation.
The tax shield, and which tax rate
Interest is deductible. When Stetron pays $22m of interest, its taxable income falls by $22m and the government effectively refunds 21% of the bill. Debt's true cost to the business is therefore the pre-tax rate multiplied by (1 − t): 5.8% × 0.79 = 4.6%. That is the tax shield, and it is why debt is cheaper than equity for two separate reasons -- lenders take less risk, and the tax code subsidises part of their bill.
Which tax rate? The statutory rate, 21%. Stetron's accounts actually show an effective rate around 33% -- earnings before tax of $194m against net income of $130m implies $64m of tax. The gap comes from non-deductible items and foreign mix, and none of it will persist. The statutory rate is the one the shield is calculated against at the margin, which is what a forward-looking discount rate needs. Using the effective rate would import one year's tax oddities into every year of the projection.
Weights: the market value trap
The weights are where most homemade WACC calculations go wrong, because the obvious source -- the balance sheet -- is the wrong one. Equity should enter at market value. The whole point of the exercise is what capital would cost to raise today, and nobody raises equity at book value.
For Stetron the gap is enormous. Book equity is $650m. Market value is 50m shares at $37.60, or $1,880m -- nearly three times book. The market is pricing Stetron's returns (about 20% on equity) at well above accounting cost, which is what happens whenever a business earns more than its cost of capital.
Watch what the wrong choice does. With book weights, debt is 34% of capital instead of 15%, and the cheap debt side dominates:
| Book weights | Market weights | |
|---|---|---|
| Equity weight | 65.7% ($650m) | 84.7% ($1,880m) |
| Debt weight | 34.3% ($340m) | 15.3% ($340m) |
| WACC | 8.0% | 9.0% |
A full point lower -- and from the sensitivity section below, a full point of WACC is worth roughly 15–20% of fair value. Building the discount rate from book weights would have inflated every Stetron valuation on this site by about a third before a single cash flow was projected. Market value of equity, book value of debt (which for a healthy company is close to market), every time.
Assembling Stetron's 9%
All five inputs are now on the table. The arithmetic is one multiplication and one addition:
| Component | Weight | Required return | Contribution |
|---|---|---|---|
| Equity | 84.7% | 9.8% | 8.30% |
| Debt (after tax) | 15.3% | 4.6% | 0.70% |
| WACC | 9.0% |
Nine percent -- not because it is between eight and ten and sounds reasonable, but because 84.7% of the capital demands 9.8% and 15.3% demands 4.6% after tax. Every DCF worked example on this site divides by this number, and now the line "discount rate 9%" has a paper trail: a Treasury yield, a beta, a disputed premium chosen from a range, a borrowing rate, a statutory tax rate, and two weights.
What one point of WACC buys and costs
The assembled rate deserves one last check, because small changes in it dominate everything else. Hold Stetron's cash flows and its 4% terminal growth fixed, and move only the discount rate:
- At 9%, the fair value of the equity is $37.60 a share -- the number used throughout this site.
- At 8%, the same business is worth roughly 15–20% more, in the mid-$40s.
- At 10%, it falls to the low-$30s.
Across a one-point change in the discount rate and a one-point change in terminal growth, Stetron's fair value spans roughly $30 to $48. That range -- not the $37.60 in the middle -- is the honest output of the analysis. It is also why the discount rate is the input worth building carefully: an error there is not one number wrong, it is the whole valuation scaled wrong.
Four ways people get WACC wrong
- Book-value weights. Covered above, and the most expensive mistake on the list: it flips the mix toward cheap debt and drags the rate down by points, inflating every valuation it touches.
- Using the coupon instead of the current rate. The rate on bonds issued years ago is a historical fact about past financing. The discount rate prices future capital. Use the marginal borrowing rate.
- Taxing twice. Entering an after-tax cost of debt into a calculator that applies the (1 − t) itself silently halves the tax shield and pushes the rate up. Know which convention your tool uses -- the WACC calculator takes the pre-tax rate and applies the shield itself.
- Ignoring the circularity. The equity weight uses the market value of equity -- but if the DCF exists to test whether the market price is fair, you are using the number you are questioning to build your own input. For a stable company the effect is mild and the standard practice is to proceed anyway; the weights move slowly and a 10% mispricing shifts the WACC by only a few tenths of a point. For a company whose price has halved or tripled, it is worth re-running the calculation with weights based on your own estimate of value.
Once the rate is built, everything downstream gets easier to trust, because the one input you could not look up is now one you can defend line by line. Run Stetron's five inputs through the WACC calculator to confirm the 9%, then carry it into the DCF calculator and watch how the fair value responds when you move it. Where the resulting number sits against the market price, and how much discount that gap deserves, is what margin of safety is for.
Related guides
- How to Value a Stock — The full valuation sequence on one worked example, from choosing a method to setting a buy price
- Margin of Safety — How big a discount a given business deserves, and why a low multiple is not the same as a discount
- Intrinsic Value vs Market Price — Why the two diverge, when cheap is not cheap, and what should force your estimate downward
More guides
- Dividend Investing — Testing whether a dividend is actually safe, using payout, cash coverage and leverage
- How to Read a Cash Flow Statement — The three sections, the eight sign combinations, and what each one warns you about
- How to Read a Balance Sheet — Reading the asset side properly: six ratios, the ROE decomposition, and four common traps
- What Is a Good P/E Ratio? — The arithmetic of a justified multiple, and the four ways a low P/E ratio lies to you
- Dividend Yield vs Total Return — Four ten-year scenarios showing why a high yield and a high return are different things
- How to Compare Two Stocks — A five-axis comparison, worked side by side, and why the cheaper multiple can be the dearer stock
- The DCF Method Explained — The forecast half of the model, worked end to end on one cash flow
- The Graham Number Explained — Graham's ceiling tested on two companies, and the three things it cannot see
- Free Cash Flow: What It Is and Why It Matters — The input every valuation depends on, including a case where profit is positive and cash flow is not
Free valuation calculators
- DCF Calculator — fair value from five years of cash flow plus terminal value
- Dividend Discount Model — Gordon Growth valuation for dividend payers
- CAGR Calculator — compound growth rate and forward projections
- Dividend Yield Calculator — yield, income per $10,000, capital needed
- Payout Ratio Calculator — dividend safety and sustainable growth
- P/E Ratio Calculator — multiple, earnings yield, PEG, target price
- Graham Number Calculator — Graham's maximum buy price
- Total Return Calculator — price change plus dividends, annualized
- EV/EBITDA Calculator — enterprise value against operating earnings
- WACC Calculator — weighted average cost of capital for discounting
- Two-Stage DDM Calculator — high-growth then stable dividend valuation
- EPS Calculator — basic and diluted earnings per share
- P/B Ratio Calculator — price against book value, with ROE context
- Margin of Safety Calculator — discount between value and price
- Compound Interest Calculator — future value with periodic contributions
- Reverse DCF Calculator — the growth rate today's price already assumes
- DuPont ROE Calculator — break return on equity into its three drivers
- Position Size Calculator — how many shares to buy for a set risk