Discount"

What Is Discount?

A discount, in finance, refers to a situation where an asset or security is trading below its intrinsic or stated value. This concept is fundamental within the broader field of Valuation, as it indicates a discrepancy between an asset's market price and its perceived worth. The presence of a discount can arise from various factors, including market sentiment, liquidity concerns, or specific characteristics of the asset itself. For instance, a bond might be issued at a discount to its Par Value, meaning its initial selling price is less than the amount the issuer promises to pay back at Maturity. Similarly, a stock might trade at a discount relative to its Net Asset Value (NAV). Understanding the nature and reasons behind a discount is crucial for investors and financial analysts, as it can highlight potential opportunities or underlying risks.

History and Origin

The concept of discounting, which is central to understanding what a discount represents, has roots in the historical practice of assessing the present value of future payments. Early forms of discounting were evident in basic lending and borrowing activities, where a future payment was valued at less than its face amount when exchanged for an immediate sum. This practice naturally led to the idea that money received in the future is worth less than the same amount received today, due to factors like the time value of money, opportunity cost, and risk.

A significant historical application of discounting is found in the operations of central banks. When the Federal Reserve was established in 1913, its "discount window" was a primary tool for providing liquidity to the banking system. Early in its history, the Federal Reserve's discount rate, the interest rate at which eligible financial institutions could borrow funds, directly influenced money market rates and was a key instrument for managing credit and monetary conditions. For example, during the 1920-21 recession, the New York Fed sharply increased its discount rate to defend its gold reserve ratio, a move that influenced economic activity.¹⁵ The term "discount" in this context refers to the practice where the interest for the loan period is deducted from the principal at the time of disbursement.¹⁴ Over time, while the discount window's role evolved, the underlying principle of valuing future payments at a reduced rate remained.

Key Takeaways

• A discount occurs when an asset's Market Price is lower than its intrinsic or stated value.
• For bonds, a common type of discount is an "original issue discount" (OID), where the bond is initially sold below its Face Value.
• Discounts can signal potential investment opportunities if the market is undervaluing an asset, but they can also indicate underlying issues or risks.
• The Federal Reserve uses a "discount rate" as a tool to lend funds to financial institutions, influencing the overall money supply and Interest Rate environment.
• Calculating the Present Value of future cash flows involves discounting those flows at an appropriate rate.

Formula and Calculation

The concept of a discount is intrinsically linked to the calculation of present value. When an asset is trading at a discount, it means its current price is less than a benchmark value, often its par value for a bond or its intrinsic value derived from future cash flows.

For a bond issued at a discount, the original issue discount (OID) is calculated as:

Where:

• Stated Redemption Price at Maturity refers to the amount the bondholder will receive when the bond matures, typically its par value.¹³
• Issue Price is the price at which the bond is initially sold to the public.¹²

Another common application involves determining the present value of future cash flows, where the discount rate is used to bring future amounts back to their current worth. The general formula for present value of a single future amount is:

Where:

• (PV) = Present Value
• (FV) = Future Value (the amount to be received in the future)
• (r) = The Discount Rate (the rate used to discount future cash flows)
• (n) = Number of periods until the future value is received

If the calculated present value is greater than the current market price, the asset might be considered to be trading at a discount.

Interpreting the Discount

Interpreting a discount involves understanding why an asset might be trading below its perceived worth and what that implies for an investor. A discount can be a sign of a market inefficiency, suggesting that the asset's true value has not yet been recognized by the broader market. For example, a closed-end fund or a real estate investment trust (REIT) might trade at a discount to its Net Asset Value (NAV), which represents the market value of its underlying assets. This could be due to a lack of investor interest, illiquidity, or concerns about management.

Conversely, a discount can also reflect genuine risks or lower quality. A bond issued at a deep discount might signal higher perceived credit risk, meaning investors demand a greater return (and thus pay a lower initial price) to compensate for the possibility of default. In corporate finance, a discount could imply that the company's Equity or Debt is viewed less favorably than its book value or the value of its assets. Careful analysis of the reasons behind a discount is essential, requiring an examination of the asset's fundamentals, market conditions, and comparative valuations.

Hypothetical Example

Consider a newly issued corporate bond with a face value of $1,000 and a maturity of five years. Due to prevailing market Interest Rates being higher than the bond's stated coupon rate, or perhaps due to the issuer's credit rating, the bond might be sold to investors at a discount.

Let's assume the bond is issued for $950. In this scenario, the discount is $50 ($1,000 - $950). This $50 is the Original Issue Discount (OID). The investor who buys this bond at $950 will receive periodic interest payments based on the coupon rate and, crucially, will receive the full $1,000 face value at maturity. The $50 discount effectively represents additional interest income that the investor will realize over the life of the bond. This OID is generally amortized and treated as income for tax purposes over the bond's holding period, even though the cash is only received at maturity.

Practical Applications

Discounts are observed across various financial markets and instruments, playing a significant role in investment analysis and decision-making.

1. Bond Markets: Bonds are frequently issued or traded at a discount. An "original issue discount" (OID) bond is one initially sold below its Par Value.¹¹ This is common for zero-coupon bonds, which pay no periodic interest but are bought at a deep discount and mature at face value. In the secondary market, a bond's price may fall to a discount if market interest rates rise above its coupon rate or if the issuer's credit quality deteriorates. For instance, municipal bonds can also be issued with an original issue discount.¹⁰
2. Equity Markets (Closed-End Funds and REITs): Closed-end funds and REITs often trade at a discount to their Net Asset Value (NAV). This means their share price is lower than the per-share value of the assets they hold. This phenomenon is a subject of ongoing financial research.⁹ For example, some U.S. equity REITs have traded at significant median discounts to their NAV, reflecting broader market sentiment or sector-specific concerns.⁸,⁷ In late 2023, some REITs were reported to be trading at steep discounts to NAV.⁶ Reuters reported on such discounts in November 2023.⁵
3. Monetary Policy: The "discount rate" is a critical tool used by central banks, such as the Federal Reserve, to manage the money supply and influence economic activity. This is the interest rate at which commercial banks can borrow funds directly from the central bank through its "discount window."⁴, The Fed can adjust this rate to provide liquidity to the banking system, especially during periods of financial stress. A lower discount rate can encourage borrowing and stimulate economic growth, while a higher rate can curb inflation.

Limitations and Criticisms

While discounts can present opportunities, their interpretation and utilization come with limitations and potential criticisms.

One primary criticism is that a persistent discount to a theoretical value, such as net asset value for a closed-end fund or REIT, does not automatically guarantee a future price appreciation. The discount could reflect fundamental issues not immediately apparent or a perpetual market inefficiency that Arbitrage opportunities cannot easily resolve due to various frictions. In the context of REITs trading at a discount to NAV, some research explores whether these departures reflect market "noise" or valid "information" regarding future property market fundamentals.³

For bonds, a deep discount might indicate significant credit risk. While the discount compensates the investor with a higher effective Yield to maturity, the risk of Default is elevated, potentially leading to a loss of principal. Investors need to differentiate between a discount arising from market rate fluctuations and one stemming from the issuer's deteriorating financial health.

Furthermore, the calculation of an intrinsic value against which a discount is measured often relies on assumptions and projections, particularly in Discounted Cash Flow (DCF) models. If these assumptions are flawed, the perceived discount may not be real. An overly optimistic forecast of future cash flows or an inappropriately low discount rate can lead to an inflated intrinsic value, making an asset appear discounted when it is, in fact, fairly priced or even overvalued. This highlights the subjective nature of valuation and the need for robust analysis beyond just observing a discount.

Discount vs. Premium

The terms "discount" and "Premium" are antonyms in finance, representing opposite conditions in an asset's pricing relative to a benchmark value.

A discount occurs when an asset's market price is below its intrinsic, par, or stated value. For example:

• A bond selling for $980 when its Face Value at maturity is $1,000 is trading at a discount.
• A closed-end fund with underlying assets worth $20 per share, but whose shares trade at $18, is trading at a discount to NAV.

Conversely, a premium occurs when an asset's market price is above its intrinsic, par, or stated value. For example:

• A bond selling for $1,020 when its par value is $1,000 is trading at a premium.
• A closed-end fund with underlying assets worth $20 per share, but whose shares trade at $22, is trading at a premium to NAV.

The confusion often arises because both conditions describe a deviation from a benchmark. However, they signify entirely different investor perceptions and market dynamics. A discount suggests that the market views the asset less favorably or that there's a perceived risk, while a premium suggests strong demand, high perceived quality, or optimistic future prospects.

FAQs

What does it mean if a stock is trading at a discount?

If a stock is trading at a discount, it means its current Share Price is lower than its calculated intrinsic value or, in the case of a fund, its net asset value (NAV). This can suggest the market is undervaluing the company, possibly due to temporary negative sentiment, specific company news, or broader market conditions. Investors might see this as a potential buying opportunity.

How does the Federal Reserve's discount rate affect the economy?

The Federal Reserve's discount rate is the interest rate at which commercial banks can borrow money from the Fed. By adjusting this rate, the Fed influences banks' cost of borrowing, which in turn can affect the broader Lending Rates and the overall money supply in the economy. Lowering the rate encourages banks to borrow more, increasing liquidity and potentially stimulating economic activity, while raising it can tighten monetary conditions.

Can a discount signal a problem with an investment?

Yes, a discount can signal a problem. While it might represent an opportunity, a discount could also be a rational market response to perceived risks, such as a company's poor financial health, high Leverage, declining industry prospects, or specific issues like lack of Liquidity for certain securities. Thorough due diligence is necessary to understand the reasons behind a discount.

Is an original issue discount (OID) taxable?

Yes, an original issue discount (OID) on a bond is generally considered a form of interest income and is taxable. For most OID bonds, the bondholder must include a portion of the OID in their gross income each year as it accrues, even if they don't receive any cash payments until the bond matures. The specific tax treatment can vary depending on the type of bond (e.g., corporate, municipal, or U.S. Treasury) and the investor's tax situation.²,¹