If you put a cookie in front of a room of kindergartners with the promise “if you don’t eat it now, you’ll get two later”, most eat the cookie. While these children aren’t necessarily acting rationally, what they are doing is saying that they’d rather less joy now than more joy in the future.
That’s the essence of the discount rate. It basically stipulates that money today is worth more than money tomorrow, and most people understand this at a fundamental level before the finance people come in and complicate things.
As people get vaccinated and the pandemic lockdowns seem to be leaving forever, economies across the world are heating up and inflation has hit recent highs. At 4%, without anything else, already $100 today is worth $96 next year. This is a first approximation of the discount rate.
But that isn’t all, if you could earn 1% risk free on that money by buying some government bonds, then the difference grows further. If we add in the opportunity cost, i.e. the amount of money you could earn on that money, then the discount rate grows even higher. Finally, we need to think about risk and put it in there as well.
All of these factors go into creating a reasonable discount rate for corporate financial planning.
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Cost of capital vs. discount rate
Before we dive into discount rate, it’s important to note that discount rate and cost of capital are often used interchangeably. While discount rate and the cost of capital are similar and related concepts, there are some key differences. Understanding both is necessary to improve your corporate finance governance.
Discount rate is used to determine the present value of future cash flows. The discount rate allows a company to calculate how much profit will come from a project over time, represented as the NPV (net present value). Since companies exist to earn profit, they need to understand the expected profitability of multi-year decisions.
Companies base their discount rate on a set of reasonable assumptions considering the inflation rate, level of risk, and the opportunity cost of their decision.
Cost of capital
The cost of capital is the company's required return. Since lenders and investors expect to be paid back and earn profit, respectively, a company needs to ensure that every new capital outlay can bring in the minimum return necessary to please the bank as well as owners.
Why do we discount?
Nobody knows what will happen in the future, which is why across the globe there are sayings such as “a bird in the hand is worth two in the bush” or “don’t count your hens before they hatch”. We simply don’t know enough about the future to feel any guarantee that we will be there to enjoy it.
This is why we value things we have now more than the things we are promised to have in the future.
In turn, this is why calculating risk and discounting based on risk is important. Let’s say you have the option to get paid $100 today or to flip a coin to potentially win $200. Would you do it? Most people probably wouldn’t since the coin flip has an expected value of $200/2, or $100, so taking the risk-free option would be more logical. But how much more would it take to convince you? A lot of this depends on the individual, but if it were, e.g., $220, then your expected risk premium would be 10%.
Beyond risk, there is opportunity cost. Opportunity cost is essentially the value of the best decision not made. For example, let’s say you sold $1000 of your S&P 500 ETF and used it across a year to start a business. If that ETF went up 30% over that year, then the opportunity cost is $300 since $300 is the money you would have earned from the decision not made.
While starting a business is a high-risk activity, businesses are usually run to minimize their risk. In this case, picking a discount rate for measuring the value of your projects is a sensible way of maintaining a conservative approach to business.
Discount rate in SaaS
So how can you use the discount rate in your SaaS business? One obvious situation is when calculating your customer lifetime value (LTV). The LTV is calculated as your average revenue per user (ARPU) times average customer lifetime (ACL).
For example, if your ARPU is $200/year and the ACL is 2 years, then your LTV is $200 × 2 = $400. This is a pretty standard calculation, but it is also completely wrong. This ignores what value you could get out of the money in the meantime as well as the risk associated with getting the money next year.
While we will go through some more practical and logical ways of building a discount rate below, for the sake of this simple example, let’s assume you’ve decided on a discount rate of 20%. In that case, the second year doesn’t add $200 to your LTV but only $160, putting your LTV at a significantly lower $360.
Why does this matter? Two things come immediately to mind: First, SaaS companies have an expense structure built highly around CAC (customer acquisition costs). Second, SaaS companies, beyond their CAC, have an average cost of service (ACS) that is heavily frontloaded by the huge R&D expenses of building, testing, and rebuilding their platforms. (PS: If all these acronyms are getting to you, check out our article on SaaS financial metrics!)
Both of these points lead to the same issue: you spend most of your money today and make most of your money tomorrow. If your CAC + ACS over those two years totals $100, then the discount rate might not matter so much. But if it is $380, then that’s the difference between making money on paper and making money in reality. Afterall, if you can earn more returns by putting money in the bank and taking a nap, then your business is in trouble.
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Discount rate chart
To give you an idea of what different discount rates look like, take a look at the chart below. While corporations tend to pick higher discount rates when defining their hurdle rate, even a 5% discount rate makes money 50 years into the future essentially worthless today.
How can the discount rate be used?
The discount rate is fundamentally used to tell you two things: the net present value (NPV) and the discounted cash flow (DCF).
The NPV is essentially the value today of all your future revenue less all your future expenses. It can be calculated for your whole company, an entire service plan, or for each customer.
While most people know about their cash flow, few appreciate their DCF. As above, when flows out happen before the revenue is making flows in, the timing and size of those flows are important. The fact that money goes out first magnifies its impact on your company and means your revenue flows in need to be even bigger and more consistent to maintain the health of your company.
The discount rate can also be used to account for the time value of money in general, compare investments that otherwise are too dissimilar for easy comparison, or calculate the riskiness of investments.
Types of discount rates
In corporate finance, the discount rate usually comes down to one of the following numbers:
The weighted average cost of capital (WACC) is used to calculate the enterprise value of a firm.
The hurdle rate is a management-defined value that indicates the minimum return on investments needed for internal capital projects.
The cost of equity is used to calculate the value of a firm.
The cost of debt is used to calculate the value of a bond.
The risk-free rate is used to account for the time value of money only.
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