Discounting is the process of determining the present value of cash to be received in the future. Assuming interest rates and/or inflation rates above zero, cash today is worth more than it will be tomorrow. Discounting quantifies this premium.

When you were studying math in school, your teacher probably taught you that a $1 investment, when compounded at 6 percent interest, will have a future value of $2 in 12.4 years, as that original $1 has earned an additional $1 in interest. What the teacher did not teach you was the reciprocal corollary: that $2 to be paid out 12.4 years from now, when discounted at 6 percent, has a present value of only $1 today.

Most M&A investments revolve around projecting how much an investment will yield in some future time horizon and figuring out what that amount of money is worth now. That is referred to as a discount rate and it determines your cost of capital.

The business of estimating M&A investment risk involves including in the discount rate two things: the certainties and uncertainties of receiving a future stream of earnings or cash flows from your investment—and your risk tolerance. The lower the certainty and/or risk tolerance, the higher the discount rate; the higher the certainty and/or risk tolerance, the lower the discount rate.