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Imagine you have the option of receiving $100 today or $120 a year from now. While you might be tempted by the larger future sum, most people would choose the guaranteed $100 today. This is because money has a time value. A dollar today is worth more than a dollar tomorrow due to factors like inflation and potential investment opportunities.
That’s the essence of the discount rate. The discount rate helps us quantify this time value. It's a rate used to calculate the present value of future cash flows. Companies consider inflation, risk, and opportunity cost when determining their discount rate. This rate is crucial for financial decisions like calculating customer lifetime value (LTV).
Discount Rate vs. Cost of Capital
Discount rates and cost of capital are often used interchangeably, but they have key differences. Both are necessary to improve corporate finance governance.
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Discount Rate: This is used to determine the present value of future cash flows. It allows a company to calculate the profit from a project over time, represented as the NPV (net present value). Companies base their discount rate on reasonable assumptions, considering the inflation rate, level of risk, and opportunity cost.
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Cost of Capital: The company’s required return. Lenders and investors expect to be paid back and earn profit, respectively. A company must ensure that every new capital outlay brings in the minimum return necessary to please both the bank and the owners.
Discount rate chart
The chart below gives you an idea of different discount rates. 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 but is essentially worthless today.
Why Do We Discount?
Nobody knows what will happen in the future, so 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 value what we have now more than what we are promised in the future.
Opportunity Cost
Opportunity cost is 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 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. However, if the business is highly successful, it could provide returns far greater than $300, illustrating the potential benefits of taking calculated risks.
Risk
Let’s say you have the option to get paid $100 today or to flip a coin to win $200 potentially. Most people probably wouldn’t take the coin flip since its expected value is $100, equal to the guaranteed option. But how much more would it take to convince you? If it were $220, then your expected risk premium would be 10%.
Discount Rate in SaaS
Calculating LTV
In SaaS businesses, the discount rate is crucial for calculating customer lifetime value (LTV). The LTV is calculated as your average revenue per user (ARPU) times the 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. However, this simple calculation ignores the time value of money and associated risks.
Assuming a discount rate of 20%, the second year doesn’t add $200 to your LTV but only $160, putting your LTV at a significantly lower $360.
Read On: If all these acronyms get to you, check out our article on SaaS financial metrics!
Importance of the Discount Rate
SaaS companies have an expense structure built around CAC (customer acquisition costs) and an average cost of service (ACS) that is frontloaded by the huge R&D expenses of building, testing, and rebuilding their platforms.
If your CAC + ACS over those two years totals $100, the discount rate might not matter much. But if it is $380, then that’s the difference between making money on paper and making money in reality.
How Can the Discount Rate Be Used?
The discount rate determines the net present value (NPV) and discounted cash flow (DCF).
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NPV: The value today of all your future revenue minus all your future expenses. It can be calculated for your whole company, an entire service plan, or each customer.
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DCF: Reflects the timing and size of cash flows, which is crucial when outflows happen before revenue inflows. The timing of these flows impacts your company, meaning revenue flows need to be substantial and consistent to maintain financial health.
Types of Discount Rates
There are several discount rates used in corporate finance, each with a specific purpose:
- Weighted Average Cost of Capital (WACC): Used to calculate a company's overall cost of capital, considering both equity and debt. It's particularly relevant for SaaS companies to understand their comprehensive cost of funding.
- Hurdle Rate: The minimum acceptable return on investment set by management. This rate often reflects the company’s risk tolerance and investment strategy.
- Cost of Equity: Determines the value of a company based on shareholder expectations.
- Cost of Debt: Calculates the value of a bond.
- Risk-Free Rate: Represents the time value of money without considering risk.
Conclusion
Understanding and applying the discount rate is vital for SaaS businesses, especially for calculating customer lifetime value and making informed financial decisions. The discount rate accounts for the time value of money, risk, and opportunity cost, ensuring that companies make profitable and sustainable choices.
Baremetrics monitors subscription revenue for businesses that generate revenue through subscription-based services. It can integrate directly with your payment gateway, such as Stripe, and pull information about your customers and their behavior into a crystal-clear dashboard.
Baremetrics brings you metrics, dunning, engagement tools, and customer insights. Some of the things Baremetrics monitors are MRR, ARR, LTV, the total number of customers, total expenses, quick ratio, and more. All of this can go a long way to figuring out and improving your NPV.
