An Empirical Analysis of DCF Discount Rates and Corresponding Weighted-Average Costs of Capital

Abstract

This paper presents the results of cross-sectional regressions to explain DCF discount rates used by investment banks and boutique valuation firms in 2,364 DCF valuations of whole companies, plus companion regressions to explain associated weighted-average costs of capital as calculated by Bloomberg. I address the possibility of valuator bias by controlling for the terminal-value assumption. DCF discount rates commonly exceed WACCs and correlate most strongly (by far) with company size. In stark contrast, WACCs correlate most strongly with beta and debt. Since DCF discount rates depend much less on capital structure than WACCs do, valuator judgment serves to bring DCF discount rates into closer conformity with Modigliani-Miller. Also, company specific risk (measured by sigma, the standard error of estimate in the market-model regression used to obtain alpha and beta) explains DCF discount rates as well as beta does, perhaps proxying for future beta.

Keywords: discounted cash flow, cost of capital