# Determine discount rate: Discounting of future earnings

## Definition: What is the discount rate?

You might assume that the value of the company will be infinite, assuming that positive earnings will flow in every year. However, this is not so, because earnings that flow to the buyer at a later point in time are worth less relative to today than earnings that are available immediately. The later the income flows in, the more it is discounted using a discount rate. The nature of this discounting regularly leads to finite income values.

The interest rate to be applied is made up of a risk-free prime rate set by the respective central bank – such as the ECB or the FED – and risk components. The risk components in turn contain a premium for the respective industry risk and a further premium for the specific company. Corporate risk depends on the size, focus and management of the company.

## Formulas: How to calculate discounting

The factor by which a future accruing income must be discounted to be comparable to today’s income is the reciprocal of ((1+interest rate) to maturity). The higher the interest rate, the greater the effect of discounting future income. If different returns are expected over the coming years, these individual future returns must be discounted individually using this formula and then added together. Income expected in two years is discounted with a term of “2”, income expected in three years with a term of “3”, etc.

For the period after a foreseeable immediate future, a discounted “perpetuity” is applied, which is added to the discounted future earnings.

## Useful tool for calculating the enterprise value

If you would like to perform a business value calculation that incorporates discounting, here is an easy-to-use calculation tool.

Dialogue