BCG Henderson Institute

Discount Rates: Back To The Future?

Now that the era of free capital has come to an end, businesses are re-embracing discounting. As strategists re-discover discounting, they should consider how to use it to manage uncertainty, strategize across timescales, and align multiple actors.

According to the Code of Hammurabi, “if a merchant […] lends money at interest, for one shekel of silver he shall receive one-fifth of a shekel as interest.” The ancient Babylonians who created this law understood that money is worth less in the future than today, because of the uncertainty of repayment and the opportunity costs of not having cash on hand for other investments.

As such, they discounted the value of future cash flows—120 shekels in a few months’ time were only as good as 100 shekels today. The practice of discounting became a staple across many economic systems. In business, modern discounted cash flow (DCF) analysis has been in widespread use since at least the 17th century.

The fall and rise of discounted cash flow analysis

In recent years, DCF has been de-emphasized as a tool for decision-making. For one, the calculation requires a clear view of future cash flows—which has become obstructed by the pace of technological progress and social, economic, and political uncertainty. Moreover, the Western world has, in the last decade, experienced a period of historically low interest rates, making the trade-off between present and future cash flows less stark. Finally, in this context, new successful business models emerged that did not focus on planning (and discounting) then executing, but on experimentation (think of the meteoric rise of agile development principles, minimum viable products, etc.), adaptiveness, and the ability to scale up offerings rapidly.

As costs of capital have rebounded, trade-offs in time have become more prominent again. With innovation being costlier and shareholders demanding higher returns sooner, companies are streamlining their businesses, becoming more selective with their investments and putting a renewed focus on profitability. Even the digital giants have pulled back on some of their major projects (Apple abandoned its car initiative, while Amazon has cut down funding for its voice assistant).

Discounting is crucial to these types of decisions. But it’s not just “back to the future” —applying DCF to singular, stable future plans and cash flow streams. In this article, we highlight four twists that strategists should consider as they reconcile current performance and future value generation.

Twist 1: Navigate diverse, uncertain scenarios

Future consumer preferences, market conditions, and geopolitical contexts are less certain than ever. This uncertainty is amplified by the increasing interconnectedness of the world, leading to the rise of second-order effects; for example, environmental regulations aiming to increase the production and adoption of electric vehicles have also increased the West’s dependence on China as the leading manufacturer of battery components. As such, reliably predicting future cash flows—a prerequisite for discounting—has become more and more difficult.

But that does not mean discounting has no use: Discount rate thinking can be applied to multiple scenarios and contingencies, assessing the sensitivity of projects to both their cash flows and to broader drivers of uncertainty, such as industry trends or geopolitical strife. Techniques like Monte Carlo simulation can then be applied to obtain an overview of the probability distribution of plausible outcomes.

Doing this will help companies become more aware of the sensitivity of their strategies to shocks, and thus, their resilience—which is key to value creation in times of turbulence. Toward this end, in evaluating projects, companies should also consider how investments (or disinvestments) affect the redundancy of their supply chain and the diversity of their business model—so that today’s striving for efficiency does not result in a lack of shock absorption capacity when the next crisis strikes.

Twist 2: Reconcile multiple, often contradicting timescales

Discounting usually assumes a single, constant discount rate—which we can use to express all cash flows in today’s terms, enabling consistent decisions across present and future. But behavioral economics research shows that this is an oversimplification. Discount rates can vary over time, as the perceived value of rewards decreases non-linearly over time—more strongly for short-term delays than of long-term payoffs. This phenomenon of discount rates rising less and less steeply over time is known as hyperbolic discounting.

In business, this and other phenomena can lead to temporal contradictions in decision-making, which result in strategies that are inconsistent between timescales. For example, many energy firms are still investing heavily into oil or methane extraction, building up infrastructure meant to operate for decades—even though their stated strategy for the long term is based on renewables.

Rigorous application of discounted cash flow analysis can help overcome this kind of problem by making the timescales of cash flows and the associated discount rates explicit. Combining this with mechanisms of progressive commitment (for example, beginning with small experiments and scaling up as the future becomes more certain) can allow companies to stay flexible and preserve optionality as the environment and circumstances evolve.

Twist 3: Reconcile preferences of various stakeholders

Businesses today are more interconnected than ever: Internally, to one another, and to their social and environmental contexts. For example, within a business, different actors have different career horizons, and different business units are confronted with different customers and competitors. In a business ecosystem, multiple parties must align their individual priorities with their common goal. More broadly, businesses are embedded in ecological and social systems. Each stakeholder has goals and timescales to consider, which can lead to conflicts of interest.

Natural ecosystems can offer inspiration for finding an optimal blend of strategies among actors with different priorities. For example, annual plants live for one growing season, focusing all their resources on rapid growth and reproduction. Perennial plants, meanwhile, live for multiple years, prioritizing long-term survival by investing their resources into sustaining themselves over the longer term. These strategies can co-exist and provide benefits for the rest of the ecosystem, as the quick-growing annuals provide an abundant source of nutrition, while the long-lasting perennials create a dependable habitat.

For companies, discount rate thinking can help find harmony across a web of disparate interests—as the preferences of each actor can be expressed as their own discount rates. Other actors’ discount rates can be deduced from dynamics in financial markets: By analyzing price signals and market rates, we gain insights into the hurdle rates companies use to assess project investments and capital allocations. But even without full-scale quantification, understanding which factors are crucial to other actors’ decisions—for instance, by observing their reactions to changes in market conditions or regulations—can be a crucial strategic asset.

For example, knowledge about others’ discount rates, and the factors influencing them, can help companies better align their strategies with partners in a digital ecosystem—where some participants may desire quick, visible payoffs, while others prefer building more slowly toward substantial payoffs. Knowing others’ preferences and tailoring strategies and communication accordingly helps foster trust. This is crucial in a collaborative ecosystem, which cannot solely rely on hierarchical control.

As an example, consider the development of the Linux kernel, to which updates are released every few months. Some contributors may push for bug fixes and stability improvements to be included in a release, reflecting a focus on the short term, while others may desire to push out novel features that may attract new users, thereby taking a longer-term perspective. Linus Torvalds manages this trade-off by encouraging open discussion on prioritization across the community of contributors and ensuring that each release features a balance of both smaller fixes and larger feature additions.

Twist 4: Complement discount rate thinking with new strategic frameworks

With capital being more expensive and investors demanding faster returns, companies need to be more selective in their investments. Discounting is key to the making these trade-off decisions within their strategies.

However, making trade-offs is not enough: Facing a multitude of plausible futures, organizations need to stay adaptive and experiment—but they must also do so more efficiently. This requires breaking the trade-off between executing on their current business models and developing a portfolio of options for future growth and competitive advantage. Toward this end, new frameworks of strategy must be embraced: One such approach, which we call radical optionality, emphasizes a greater blend of execution and companies’ exploration processes.

Now that the era of free capital has come to an end, business models built on broad experimentation and rapid scale-ups are coming under threat. Firms are re-embracing discounting—that time-tested, ubiquitous tool for selecting investments based on their future payoffs. Discounting is crucial for trimming portfolios and selecting which new opportunities to pursue. As strategists re-discover discount rate thinking, they should consider how to use it to manage uncertainty, strategize across timescales, and align multiple actors. Moreover, they must complement this classic toolkit with new strategic regimes that enable breaking the trade-off between short-term payoffs and long-term value generation.

Sources & Notes