Monday, February 2, 2009

Low riskfree rates...

One of the many perils of valuing a company in the US or Europe right now is that the riskfree rates in US dollars and Euros are at unprecedented lows - about 2.3% in US $ and about 2.8% in Euros. Analysts, confronted with these riskfree rates, are faced with a quandary. If they use the low riskfree rates, they end up with low discount rates which then result in high valuations. To get around this problem, many are asking the question: Are riskfree rates too low and should we replace them with higher normalized rates (perhaps average rates over time)? Good question, but the wrong place to ask it...

Let me take a step back. It is true that riskfree rates are low but they are not the only numbers at unusual levels. Equity risk premiums and default spreads are at historical highs and the worry about global economic growth is deeper than at time in recent history. When we use low riskfree rates in valuation, we have to accompany them with much higher risk premiums than we would have used a few months ago, lower real growth and lower expected inflation. The net effect is that intrinsic values are lower now than they were a few months ago. 

What gets analysts into trouble is inconsistency. If we use today's riskfree rates and stick with risk premiums that we used to use in the past and growth rates and inflation rates that are also from the past, we will over value companies. The culprit is not the low riskfree rates but internal inconsistency. 

My advice is that you stay with today's riskfree rates but update the other numbers you use in valuation to reflect the environment we face right now. If you insist on replacing today's riskfree rate with your normalized number, you should then adjust all your other numbers to be consistent - not easy to do, in my view. 

Finally, I have a paper on riskfree rates that you may find useful (or not). You can find it by clicking on this link.
I hope you find it useful.


14 comments:

Saurav Roychoudhury said...

Thanks! Thats what I am doing in my class. I am still using the unusually low risk free rates for both short term (for eg. 0.22% for 3 month T-bill today) and long term horizons (2.72% on a 10 year G-Bond today) but I am using a higher equity risk premium (about 9%-10%) and a higher Default spread (updated from your recent ratings calculator)when I am doing the cost of debt (I have actually increased the spread by few basis points, more for lower ratings). Still we have unusually high Liquidity premium which accounts for about 100-500bp differences in similar bonds (same maturity and ratings)

not-so-erudite said...

Professor--9-10% as an equity premium seems too high though an implied premium of 6.43% based upon a 4% growth in earnings for the S&P over five years also doesn't seem quite right. What is your thinking on the best way to calculate this crucial input?

Saurav Roychoudhury said...

My belief would be that if we use the implied premium of 6.43% or lower in conjunction with the super-low risk free rates, this will under-estimate the required rate of return, hence the cost of equity as well as the hurdle rate.Put it in other words, if the risk premium is around 6.43%, why are investors not snapping up stocks (which would be a bargain, right?) or Companies taking up new projects (or even replacing older projects). It is because the required return for holding the stock has gone way up (and the expected return has gone down or atleast remained the same) and so have the hurdle rate and the only way that can explain this is that the marginal investor or the company has a higher risk premium than (ever?) before. Hence it might be reasonable to assign a higher number for risk premium atleast for now. I would like Prof. Damodaran if he can shed more light on this, thanks

Aswath Damodaran said...

I don't think so... I valued about 30 companies in the last few weeks for my second edition of the Dark Side of Valuation. While I found some companies to be under and some over valued, the average across the 30 companies, using today's riskfree rates and a 6.43% risk premium worked out to about where the market is today....

hamishb' said...

The risk free rate is nominal i.e. it reflects the real interest rate plus inflation expectations.

When risk free rates are compared to inflation linked bonds, one can see where the market is expecting inflation to head.

So from a consistency perspective, should the inflation applied to the cash flows be similar to the inflation reflected it the current risk free rate?

Or is there a view that says the real interest rate is at historical lows?

Any thoughts?

Nataliya said...

Aswath, do you have any thoughs about risk-free rate for emerging markets? One of the ideas I've heard was to use forward exchange rates and US dollars risk-free rate. Can you suggest any other method?

Aswath Damodaran said...

You can back a riskfree rate out of forward rates, if you can find them for a long enough time period.

Pensamientos Neoliberales said...

Excellent post professor. And I completely agree with your approach.

Gaurav Mehta said...

Hi sir,

Given that the S&P 500 is at around 850 presently the intrinsic risk premium calculates to around 6.85% assuming the dividends and buybacks this year! I just wanted to clarify if the markets were to rebound later this year or next year given the intrinsic level of the marke to be atleast 1300...the risk premium would decrease too... so doesn't this imply that the valuations we do at this point in time would be relevant for very short term ??

Gaurav Mehta said...

In the last comment obviously i meant using the implied premium for valuations.

Kisek said...

Dear professor. I very appreciate your contribution for valuation progress. Your methodology is the most frequently used in the Czech Republic that I am from.

I have one question on you regarding the risk-free rate as a component of the ERP presented on your websites. You compute T.Bond (10Y) return as its rate reduced by price change resulted from coupon rate change.

My questions are:
1.) Why do you make this adjustment? Notwithstanding if you hold the bond up to its maturity you will get the coupons regularly and the nominal value at the end.
2.) Is there any difference between your approach of T.Bond return computation and the "bond income return" mentioned e.g. by Mr. Ibbotson or Mr. Pratt?
2.) Is your approach consistent with computation of risk-free rate as the first part of the cost of equity formula: C(e) = r(f) + ERP*beta. In this case we use nominal T.Bonds rate.

Thank you very much.

fahbah said...

ABC derives 60% of its revenues from US (low growth and low inflation market) and 40% from markets like India/ China (much higher growth rates and inflation). While the forecasted cash flows are reported in USD, taking US risk free rate of 3% will not account for the higher growth and inflation emanating from my export markets (India and China). Thus there would be a potential mismatch between the real growth and inflation built into the US risk free rate the forecasted cash flows.

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