Discount rate: cost of equity and WACC

The discount rate converts future cash into today's money and carries the risk. The firm's cash flows are discounted at the weighted average cost of capital, the blended return that equity holders and lenders require.

$E$ is the market value of equity, price times diluted shares. $D$ is total debt including leases. Interest is tax-deductible, so the cost of debt enters after tax at the marginal rate.

Cost of equity: CAPM

The capital asset pricing model says investors demand the risk-free rate plus a premium for bearing market risk. The equity risk premium (ERP) is what the whole market is expected to return above the risk-free rate. Beta scales that premium: a stock with beta 1.5 moves half again as much as the market and must pay a premium half again as large. The risk-free rate is the 10-year Treasury yield from FRED. The ERP is Damodaran's implied premium, backed out of the current index price and expected cash flows.

Three ways to get beta

• Regression. Slope of the stock's weekly returns on the S&P 500's, then Blume-adjusted. Blume showed that estimated betas revert toward 1 over time, so the raw slope is shrunk:
  $$\beta_{\text{adj}} = 0.67\,\beta_{\text{raw}} + 0.33$$
• Bottom-up. Take the average unlevered beta of the company's sector, which is the business risk with debt stripped out, and re-lever it to this company's debt-to-equity ratio with the Hamada equation:
  $$\beta_L = \beta_U\left[1 + (1-\tau)\frac{D}{E}\right]$$
  Sector averages are estimated from many companies, so they are far less noisy than one stock's regression. Damodaran recommends this as the default.
• Manual. Enter your own.

Cost of debt: synthetic rating

Most companies have no traded bonds, so the engine infers a credit rating from how comfortably operating profit covers interest, then adds the default spread that rating commands:

The book alternative divides interest expense by total debt, which measures what the company pays on old debt rather than what new debt would cost.