For many people, myself included, the term ‘discount’means: “Nordstrom’s Final Clearance: Now is your chance for great savings on all Womens’ Summer Fashions, including Apparel, Shoes, Handbags, Jewelry, Makeup, Socks, Fragrances, Ceiling Tiles, Glue Sticks, etc…” You get the idea, easy right? A discount is a reduction in price of a good or service. We discount to increase short-term sales, move dusty out-of-date inventory, reward valuable customers, etc. Discounts reduce the price of a good for any number of reasons.
Let’s connect the dots.
I want you to close your eyes and imagine someone else reading this to you: you walk into your favorite retail store with a coupon clipped from last week’s paper. For months you’ve drooled over the the La-Z-Boy Supreme Deluxe Recliner with built in massage, cup holders, mini fridge, and ventilation system, and it’s FINALLY on sale. Previously the chair was listed at $1,000, but because you sent your kids to boarding school at your wife’s behest, the La-Z-Boy’s cost was too high relative to its satisfaction. But with your new 30% off coupon, the rules have changed and your wallet and wife might approve.
In Economics there’s an idea of equilibrium, the point at which quantity demanded and quantity supplied are equal. If a market has too much of a product, or surplus of supply, the price should drop to return to equilibrium. Conversely if there is not enough of a certain product, the price should rise in order to reach equilibrium. In the case of an individual, equilibrium is where the price of a product meets your relative satisfaction, also known as the point of indifference.
Still with me? Good!
Back to the La-Z-Boy… We assume there was an overstock of La-Z-Boy Supreme Deluxe Recliners, which relaxes (get it?) the price as well as increases the quantity demanded. As a result: cheaper chair, more chairs sold!
We now fully understand the idea of a discount and why it works, so let’s see it in financial action. Can we discount an investment? If we were to discount an investment, much like a US Treasury is sold at a discount to its face value, we would be accommodating the cost of our risks rather than discounting a good to meet our relative satisfaction. If we think about equilibrium and replace the idea of relative satisfaction with the value of risk, we can suppose that someone is willing to pay more for an investment with decreased risk, and less for an investment with increased risk.
When you purchase an investment, you are essentially purchasing the right to collect the future cash flows that the investment produces. And as we have learned before, Time Value of Money states that money today is worth more than money tomorrow. So in order to quantify how much that future cash flow is worth today, we discount the Future Values to a Present Value. Without going much into detail, as it will be discussed in a later post, Present Value applies a discount rate to an investment’s future cash flow to account for risk and inflation, and calculate a value today.
And finally, remember that the relative satisfaction gained from purchasing a jealousy-inducing, back-massaging, cup-holding, mini-fridging, air-ventilating, awe-inspiring La-Z-Boy Supreme Deluxe Recliner without the wife’s permission is rarely ever worth the cost of having to sleep on it every night for the next few months. It would be well advised to wait for a discount.