Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question!

    In the first five posts, I have looked at the macro numbers that drive global markets, from interest rates to risk premiums, but it is not my preferred habitat. I spend most of my time in the far less rarefied air of corporate finance and valuation, where businesses try to decide what projects to invest in, and investors attempt to estimate business value. A key tool in both endeavors is a hurdle rate – a rate of return that you determine as your required return for business and investment decisions. In this post, I will drill down to what it is that determines the hurdle rate for a business, bringing in what business it is in, how much debt it is burdened with and what geographies it operates in.

The Hurdle Rate - Intuition and Uses

    You don't need to complete a corporate finance or valuation class to encounter hurdle rates in practice, usually taking the form of costs of equity and capital, but taking a finance class both deepens the acquaintance and ruins it. It deepens the acquaintance because you encounter hurdle rates in almost every aspect of finance, and it ruins it, by making these hurdle rates all about equations and models. A few years ago, I wrote a paper for practitioners on the cost of capital, where I described the cost of capital as the Swiss Army knife of finance, because of its many uses. 

    In my corporate finance class, where I look at the first principles of finance that govern how you run a business, the cost of capital shows up in every aspect of corporate financial analysis:

• In business investing (capital budgeting and acquisition) decisions, it becomes a hurdle rate for investing, where you use it to decide whether and what to invest in, based on what you can earn on an investment, relative to the hurdle rate. In this role, the cost of capital is an opportunity cost, measuring returns you can earn on investments on equivalent risk.
  
  
  
• In business financing decisions, the cost of capital becomes an optimizing tool, where businesses look for a mix of debt and equity that reduces the cost of capital, and where matching up the debt (in terms of currency and maturity) to the assets reduces default risk and the cost of capital. In this context, the cost of capital become a measure of the cost of funding a business:
  
  
  
• In dividend decisions, i.e., the decisions of how much cash to return to owners and in what form (dividends or buybacks), the cost of capital is a divining rod. If the investments that a business is looking at earn less than the cost of capital, it is a trigger for returning more cash, and whether it should be in the form of dividends or buybacks is largely a function of what shareholders in that company prefer:
  

The end game in corporate finance is maximizing value, and in my valuation class, where I look at businesses from the outside (as a potential investor), the cost of capital reappears again as the risk-adjusted discount rate that you use estimate the intrinsic value of a business. 

Much of the confusion in applying cost of capital comes from not recognizing that it morphs, depending on where it is being used. An investor looking at a company, looking at valuing the company, may attach one cost of capital to value the company, but within a company, but within a company, it may start as a funding cost, as the company seeks capital to fund its business, but when looking at investment, it becomes an opportunity cost, reflecting the risk of the investment being considered.

The Hurdle Rate - Ingredients

    If the cost of capital is a driver of so much of what we do in corporate finance and valuation, it stands to reason that we should be clear about the ingredients that go into it. Using one of my favored structures for understanding financial decision making, a financial balance sheet, a cost of capital is composed of the cost of equity and the cost of debt, and I try to capture the essence of what we are trying to estimate with each one in the picture below:

To go from abstractions about equity risk and default risk to actual costs, you have to break down the costs of equity and debt into parts, and I try to do so, in the picture below, with the factors that you underlie each piece:

As you can see, most of the items in these calculations should be familiar, if you have read my first five data posts, since they are macro variables, having nothing to do with individual companies.  

• The first is, of course, the riskfree rate, a number that varies across time (as you saw in post on US treasury rates in data update 4) and across currencies (in my post on currencies in data update 5). 
• The second set of inputs are prices of risk, in both the equity and debt markets, with the former measured by equity risk premiums, and the latter by default spreads. In data update 2, I looked at equity risk premiums in the United States, and expanded that discussion to equity risk premiums in the rest of the world in data update 5). In data update 4, I looked at movements in corporate default spreads during 2024.

There are three company-specific numbers that enter the calculation, all of which contribute to costs of capital varying across companies;

• Relative Equity Risk, i.e., a measure of how risky a company's equity is, relative to the average company's equity. While much of the discussion of this measure gets mired in the capital asset pricing model, and the supposed adequacies and inadequacies of beta, I think that too much is made of it, and that the model is adaptable enough to allow for other measures of relative risk.
  
  I am not a purist on this measure, and while I use betas in my computations, I am open to using alternate measures of relative equity risk.
• Corporate Default Risk, i.e, a measure of how much default risk there is in a company, with higher default risk translating into higher default spreads. For a fairly large subset of firms, a bond rating may stand in as this measure, but even in its absence, you have no choice but to estimate default risk. Adding to the estimation challenge is the fact that as a company borrows more money, it will play out in the default risk (increasing it), with consequences for both the cost of equity and debt (increasing both of those as well).
• Operating geographies:  The equity risk premium for a company does not come from where it is  incorporated but from where it does business, both in terms of the production of its products and services and where it generates revenue. That said, the status quo in valuation in much of the world seems to be to base the equity risk premium entirely on the country of incorporation, and I vehemently disagree with that practice:
  
  Again, I am flexible in how operating risk exposure is measured, basing it entirely on revenues for consumer product and business service companies, entirely on production for natural resource companies and a mix of revenues and production for manufacturing companies.

As you can see, the elements that go into a cost of capital are dynamic and subjective, in the sense that there can be differences in how one goes about estimating them, but they cannot be figments of your imagination.

The Hurdle Rate - Estimation in 2025

    With that long lead in, I will lay out the estimation choices I used to estimate the costs of equity, debt and capital for the close to 48,000 firms in my sample. In making these choices, I operated under the obvious constraint of the raw data that I had on individual companies and the ease with which I could convert that data into cost of capital inputs. 

1. Riskfree rate: To allow for comparisons and consolidation across companies that operate in different currencies, I chose to estimate the costs of capital for all companies in US dollars, with the US ten-year treasury rate on January 1, 2025, as the riskfree rate.
2. Equity Risk Premium: Much as I would have liked to compute the equity risk premium for every company, based upon its geographic operating exposure, the raw data did not lend itself easily to the computation. Consequently, I have used the equity risk premium of the country in which a company is headquartered to compute the equity risk premium for it.
3. Relative Equity Risk: I stay with beta, notwithstanding the criticism of its effectiveness for two reasons. First, I use industry average betas, adjusted for leverage, rather than the company regression beta, because because the averages (I title them bottom up betas) are significantly better at explaining differences in returns across stocks. Second, and given my choice of industry average betas, none of the other relative risk measures come close, in terms of predictive ability. For individual companies, I do use the beta of their primary business as the beta of the company, because the raw data that I have does not allow for a breakdown into businesses. 
4. Corporate default risk: For the subset of the sample of companies with bond ratings, I use the S&P bond rating for the company to estimate the cost of debt. For the remaining companies, I use interest coverage ratios as a first measure to estimate synthetic ratings, and standard deviation in stock prices as back-up measure.
5. Debt mix: I used the market capitalization to measure the market value of equity, and stayed with total debt (including lease debt) to estimate debt to capital and debt to equity ratios

The picture below summarizes my choices:

There are clearly approximations that I used in computing these global costs of capital that I would not use if I were computing a cost of capital for valuing an individual company, but this approach yields values that can yield valuable insights, especially when aggregated and averaged across groups.

a. Sectors and Industries

    The risks of operating a business will vary  widely across different sectors, and I will start by looking at the resulting differences in cost of capital, across sectors, for global companies:

There are few surprises here, with technology companies facing the highest costs of capital and financials the lowest, with the former pushed up by high operating risk and a resulting reliance on equity for capital, and the latter holding on because of regulatory protection.

    Broken down into industries, and ranking industries from highest to lowest costs of capital, here is the list that emerges:

Download industry costs of capital

The numbers in these tables may be what you would expect to see, but there are a couple of powerful lessons in there that businesses ignore at their own peril. The first is that even a casual perusal of differences in costs of capital across industries indicates that they are highest in businesses with high growth potential and lowest in mature or declining businesses, bringing home again the linkage between danger and opportunity. The second is that multi-business companies should understand that the cost of capital will vary across businesses, and using one corporate cost of capital for all of them is a recipe for cross subsidization and value destruction.

b. Small versus Larger firms

    In my third data update for this year, I took a brief look at the small cap premium, i.e, the premium that small cap stocks have historically earned over large cap stocks of equivalent risk, and commented on its disappearance over the last four decades. I heard from a few small cap investors, who argued that small cap stocks are riskier than large cap stocks, and should earn higher returns to compensate for that risk. Perhaps, but that has no bearing on whether there is a small cap premium, since the premium is a return earned over and above what you would expect to earn given risk, but I remained curious as to whether the conventional wisdom that small cap companies face higher hurdle rates is true. To answer this question, I examine the relationship between risk and market cap, breaking companies down into market cap deciles at the start of 2025, and estimating the cost of capital for companies within each decile:

The results are mixed. Looking at the median costs of capital, there is no detectable pattern in the cost of capital, and the companies in the bottom decile have a lower median cost of capital (8.88%) than the median company in the sample (9.06%). That said, the safest companies in  largest market cap decile have lower costs of capital than the safest companies in the smaller market capitalizations. As a generalization, if small companies are at a disadvantage when they compete against larger companies, that disadvantage is more likely to manifest in difficulties growing and a higher operating cost structure, not in a higher hurdle rate.

c. Global Distribution

    In the final part of this analysis, I looked at the costs of capital of all publicly traded firms and played some Moneyball, looking at the distribution of costs of capital across all firms. In the graph below,I present the histogram of cost of capital, in US dollar terms, of all global companies at the start of 2025, with a breakdown of costs of capital, by region, below:

I find this table to be one of the most useful pieces of data that I possess and I use it in almost every aspect of corporate finance and valuation:

1. Cost of capital calculation: The full cost of capital calculation is not complex, but it does require inputs about operating risk, leverage and default risk that can be hard to estimate or assess for young companies or companies with little history (operating and market). For those companies, I often use the distribution to estimate the cost of capital to use in valuing the company. Thus, when I valued Uber in June 2014, I used the cost of capital (12%) at the 90th percentile of US companies, in 2014, as Uber's cost of capital. Not only did that remove a time consuming task from my to-do list, but it also allowed me to focus on the much more important questions of  revenue growth and margins for a young company. Drawing on my fifth data update, where I talk about differences across currencies, this table can be easily modified into the currency of your choice, by adding differential inflation. Thus, if you are valuing an Indian IPO, in rupees, and you believe it is risky, at the start of 2025, adding an extra 2% (for the inflation differential between rupees and dollars in 2025) to the ninth decile of Indian costs of capital (12.08% in US dollars) will give you a 14.08% Indian rupee cost of capital.
2. Fantasy hurdle rates: In my experience, many  investors and companies make up hurdle rates, the former to value companies and the latter to use in investment analysis. These hurdle rates are either hopeful thinking on the part of investors who want to make that return or reflect inertia, where they were set in stone decades ago and have never been revisited. In the context of checking to see whether a valuation passes the 3P test (Is it possible? Is it plausible? Is it probable?), I do check the cost of capital used in the valuation. A valuation in January 2025, in US dollars, that uses a 15% cost of capital for a publicly traded company that is mature is fantasy (since it is in well in excess of the 90th percentile), and the rest of the valuation becomes moot. 
3. Time-varying hurdle rates: When valuing companies, I believe in maintaining consistency, and one of the places I would expect it to show up is in hurdle rates that change over time, as the company's story changes. Thus, if you are valuing a money-losing and high growth company, you would expect its cost of capital to be high, at the start of the valuation, but as you build in expectations of lower growth and profitability in future years, I would expect the hurdle rate to decrease (from close to the ninth decile in the table above towards the median).

It is worth emphasizing that since my riskfree rate is always the current rate, and my equity risk premiums are implied, i.e., they are backed out from how stocks are priced, my estimates of costs of capital represent market prices for risk, not theoretical models. Thus, if looking at the table, you decide that a number (median for your region, 90th percentile in US) look too low or too high, your issues are with the market, not with me (or my assumptions).

Takeaways

    I am sorry that this post has gone on as long as it has, but to end, there are four takeaways from looking at the data:

1. Corporate hurdle rate: The notion that there is a corporate hurdle rate that can be used to assess investments across the company is a myth, and one with dangerous consequences. It plays out in all divisions in a multi-business company using the same (corporate) cost of capital and in acquisitions, where the acquiring firm's cost of capital is used to value the target firm. The consequences are predictable and damaging, since with this practice, safe businesses will subsidize risky businesses, and over time, making the company riskier and worse off over time.
2. Reality check on hurdle rates: All too often, I have heard CFOs of companies, when confronted with a cost of capital calculated using market risk parameters and the company's risk profile, say that it looks too low, especially in the decade of low interest rates, or sometimes, too high, especially if they operate in an risky, high-interest rate environment. As I noted in the last section, making up hurdle rates (higher or lower than the market-conscious number) is almost never a good idea, since it violates the principle that you have live and operate in the world/market you are in, not the one you wished you were in.
3. Hurdle rates are dynamic: In both corporate and investment settings, there is this almost desperate desire for stability in hurdle rates. I understand the pull of stability, since it is easier to run a business when hurdle rates are not volatile, but again, the market acts as a reality check. In a world of volatile interest rates and risk premia, using a cost of capital that is a constant is a sign of denial.
4. Hurdle rates are not where business/valuation battles are won or lost: It is true that costs of capital are the D in a DCF, but they are not and should never be what makes or breaks a valuation. In my four decades of valuation, I have been badly mistaken many times, and the culprit almost always has been an error on forecasting growth, profitability or reinvestment (all of which lead into the cash flows), not the discount rate. In the same vein, I cannot think of a single great company that got to greatness because of its skill in finessing its cost of capital, and I know of plenty that are worth trillions of dollars, in spite of never having actively thought about how to optimize their costs of capital. It follows that if  you are spending the bulk of your time in a capital budgeting or a valuation, estimating discount rates and debating risk premiums or betas, you have lost the script. If you are valuing a mature US company at the start of 2025, and you are in a hurry (and who isn't?), you would be well served using a cost of capital of 8.35% (the median for US companies at the start of 2025) and spending your time assessing its growth and profit prospects, and coming back to tweak the cost of capital at the end, if you have the time.

YouTube Video

Data Updates for 2025

1. Data Update 1 for 2025: The Draw (and Danger) of Data!
2. Data Update 2 for 2025: The Party continued for US Equities
3. Data Update 3 for 2025: The times they are a'changin'!
4. Data Update 4 for 2025: Interest Rates, Inflation and Central Banks!
5. Data Update 5 for 2025: It's a small world, after all!
6. Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question!
7. Data Update 7 for 2025: The End Game in Business!
8. Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta!
9. Data Update 9 for 2025: Dividend Policy - Inertia and Me-tooism Rule!

Data Links

1. Cost of capital, by industry grouping: US, Global, Emerging Markets, Japan, Europe, India, China)
2. Cost of capital distribution, by industry

Paper links

1. The Cost of Capital: The Swiss Army Knife of Finance

Country Risk: My 2024 Data Update

After the 2008 market crisis, I resolved that I would be far more organized in my assessments and updating of equity risk premiums, in the United States and abroad, as I looked at the damage that can be inflicted on intrinsic value by significant shifts in risk premiums, i.e., my definition of a crisis. That precipitated my practice of estimating implied equity risk premiums for the S&P 500, at the start of every month, and following up of using those estimated premiums when valuing companies during that month. The 2008 crisis also gave rise to two risk premium papers that I have updated each year: the first looks at equity risk premiums, what they measure, how they vary across time and how best to estimate them, with the last update in March 2024. The second focuses on country risk and how it varies across geographies, with the focus again on determinants, measures and estimation, which I update mid-year each year. This post reflects my most recent update from July 2024 of country risk, and while you can read the entire paper here, I thought I would give you a mildly abridged version in this post.

Country Risk: Determinants

    At the risk of stating the obvious, investing and operating in some countries is much riskier than investing and operating in others, with variations in risk on  multiple dimensions. In the section below, I highlight the differences on four major dimensions - political structure, exposure to war/violence, extent of corruption and protections for legal and property rights, with the focus firmly on the economic risks rather than on social consequences.

a. Political Structure

    Would you rather invest/operate in a democracy than in an autocracy? From a business risk perspective, I would argue that there is a trade off, sometimes making the former more risky than the latter, and sometimes less so. The nature of a democracy is that a government will be less able to promise or deliver long term predictable/stable tax and regulatory law, since losing an election can cause shifts in policy. Consequently, operating and investing in a democratic country will generally come with more risk on a continuous basis, with the risk increasing with partisanship in the country. Autocratic governments are in a better position to promise and deliver stable and predictable business environments, with two caveats. The first is that when change comes in autocracies, it will be both unexpected and large, with wrenching and discontinuous shifts in economic policy. The second is that the absence of checks and balance (legal, legislative, public opinion) will also mean that policy changes can be capricious, often driven by factors that have little to do with business or public welfare. 

    Any attempt to measure political freedom comes with qualifiers, since the biases of the measuring service on what freedoms to elevate and which ones to ignore will play a role, but in the figure below, I report the Economist's Democracy Index, which is based upon five measures - electoral process and pluralism, government functioning, political participation, democratic social culture and civil liberties:

Democracy Index in 2023: Source: The Economist

Based upon the Economist's democracy measures, much of the world remains skewed towards authoritarianism, changing the risk exposures that investors and businesses face when operating in those parts of the world. 

b. War and Violence

    Operating a business becomes much more difficult, when surrounded by war and violence, from both within and outside the country. That difficulty also translates into higher costs, with those businesses that can buy protection or insurance doing so, and those that cannot suffering from damage and lost revenues. Drawing again on an external service, the Institute for Economics and Peace measures exposure to war and violence with a global peace index (with higher scores indicating more propensity towards violence):

Global Peace Index 2024: Source: Institute for Economics & Peace

While Africa and large swaths of Asia are exposed to violence, and Northern Europe and Canada remain peaceful, businesses in much of the world (including the United States) remain exposed to violence, at least according to this measure.

c. Corruption

    As I have argued in prior posts, corruption operates as an implicit tax on businesses, with the tax revenues accruing to middlemen or third parties, rather than the government. 

Corruption Index 2023: Source: Transparency International

Again, while you can argue with the scores and the rankings, it remains undeniable that businesses in much of the world face corruption (and its associated costs). While there are some who attribute it to culture, I believe that the overriding reasons for corruption are systems that are built around licensing and regulatory constraints, with poorly paid bureaucrats operating as the overseers 

    There are other insidious consequences to corruption. First, as corruption becomes brazen, as it is in some parts of the world, there is evidence that companies operating in those settings are more likely to evade paying taxes to the government, thus redirecting tax revenues from the government to private players. Second, companies that are able and willing to play the corruption game will be put at an advantage over companies that are unable or unwilling to do so, creating a version of Gresham's law in businesses, where the least honorable businesses win out at the expense of the most honorable and honest ones. 

d. Legal and Property Rights

    When operating a business or making an investment, you are reliant on a legal system to back up your ownership rights, and to the extent that it does not do so, your business and investment will be worth less. The Property Rights Alliance, an entity that attempts to measure the strength of property rights, by country, measured property rights (physical and intellectual) around the world, to come up with a composite measure of these rights, with higher values translating into more rights. Their most recent update, from 2023, is captured in the picture below:

Property Rights Index 2023: Source: The Property Rights Alliance

Again, there are wide differences in property rights across the world; they are strongest in the North America and Europe and weakest in Africa and Latin America. Within each of these regions, though, there are variations across countries; within Latin America, Chile and Uruguay rank in the top quartile of countries with stronger property rights, but Venezuela and Bolivia are towards the bottom of the list. In assessing protections of property rights, it is worth noting that it is not only the laws that protect them that need to be looked at, but also the timeliness of legal action. A court that takes decades to act on violations of property rights is almost as bad as a court that does not enforce those rights at all.

    One manifestation of property right violation is nationalization, and here again there remain parts of the world, especially with natural resource businesses, where the risks of expropriation have increased. A Sustainalytics report that looked at metal miners documented 165 incidents of resources nationalization between 2017 and 2021, impacting 87 mining companies, with 22 extreme cases, where local governments ending contracts with foreign miners. Maplecroft, a risk management company, mapped out the trendline on nationalization risk in natural resources in the figure below:

Source: Maplecroft

National security is the reason that some governments use to justify public ownership of key resources. For instance, in 2022, Mexico created a state-owned company, Litio Para Mexico, to have a monopoly on lithium mining in the country, and announced a plan to renegotiate previously granted concessions to private companies to extract the resource.

Country Risk: External factors

    Looking at the last section, you would not be faulted for believing that country risk exposure is self-determined, and that countries can become less risky by working on reducing corruption, increasing  legal protections for property rights, making themselves safer and working on more predictable economic policies.  That is true, but there are three factors that are largely out of their control that can still drive country risk upwards.

1. Commodity Dependence

    Some countries are dependent upon a specific commodity, product or service for their economic success. That dependence can create additional risk for investors and businesses, since a drop in the commodity’s price or demand for the product/service can create severe economic pain that spreads well beyond the companies immediately affected. Thus, if a country derives 50% of its economic output from iron ore, a drop in the price of iron ore will cause pain not only for mining companies but also for retailers, restaurants and consumer product companies in the country. The United Nations Conference on Trade and Development (UNCTAD) measures the degree to which a country is dependent on commodities, by looking at the percentage of its export revenues come from a commodities, and the figure below captures their findings:

Proportion of revenues from commodities- 2019-2021; Source: UNCTAD

Why don’t countries that derive a disproportionate amount of their economy from a single source diversify their economies? That is easier said than done, for two reasons. First, while it is feasible for larger countries like Brazil, India, and China to try to broaden their economic bases, it is much more difficult for small countries like Peru or Angola to do the same. Like small companies, these small countries have to find a niche where they can specialize, and by definition, niches will lead to over dependence upon one or a few sources. Second, and this is especially the case with natural resource dependent countries, the wealth that can be created by exploiting the natural resource will usually be far greater than using resources elsewhere in the economy, which may explain the inability of economies in the Middle East to wean itself away from oil. 

II. Life Cycle dynamics

    As readers of this blog should be aware, I am fond of using the corporate life cycle structure to explain why companies behave (or misbehave) and how investment philosophies vary. At the risk of pushing that structure to its limits, I believe that countries also go through a life cycle, with different challenges and risks at each stage:

The link between life cycle and economic risk is worth emphasizing because it illustrates the limitations on the powers that countries have over their exposure to risk. A country that is still in the early stages of economic growth will generally have more risk exposure than a mature country, even if it is well governed and has a solid legal system. The old investment saying that gain usually comes with pain, also applies to operating and investing across the globe. While your risk averse side may lead you to direct your investments and operations to the safest parts of the world (say, Canada and Northern Europe), the highest growth is generally in the riskiest parts of the world.

3. Climate Change

    The globe is warming up, and no matter where you fall on the human versus nature debate, on causation, some countries are more exposed to global warming than others. That risk is not just to the health and wellbeing of those who live within the borders of these countries, but represents economic risks, manifesting as higher costs of maintaining day-to-day activity or less economic production.  To measure climate change, we turned to ResourceWatch, a global partnership of public, private and civil society organizations convened by the World Resources Institute. This institute measure climate change exposure with a climate risk index (CRI), measuring the extent to which countries have been affected by extreme weather events (meteorological, hydrological, and climatological), and their most recent measures (from 2021, with an update expected late in 2024) of global exposure to climate risk is in the figure below:

Climate Risk Index (CRI) in 2021: ResourceWatch

Note that higher scores on the index indicate more exposure to country risk, and much of Africa, Latin America and Asia are exposed. In fact, since this map was last updated in 2021, it is conceivable that climate risk exposure has increased across the globe and that even the green regions are at risk of slipping away into dangerous territory.

Country Life Cycle - Measures

    With that long lead in on the determinants of country risk, and the forces that can leave risk elevated, let us look at how best to measure country risk exposure. We will start with sovereign ratings, which are focused on country default risk, because they are the most widely used country risk proxies, before moving on to country risk scores, from public and private services, and closing with measures of risk premiums that equity investors in these countries should charge.

1. Sovereign Default Risk

    The ratings agencies that rate corporate bonds for default risk also rate countries, with sovereign ratings, with countries with higher (lower) perceived default risk receiving lower (higher) ratings. I know that ratings agencies are viewed with skepticism, and much of that skepticism is deserved, but it is undeniable that ratings and default risk are closely tied, especially over longer periods. The figure below summarizes sovereign ratings from Moody's in July 2024:

Moody's Sovereign Ratings in July 2024; Source: Moody's

If you compare these ratings to those that I reported in my last update, a year ago, you will notice that the ratings are stagnant for most countries, and when there is change, it is small. That remains my pet peeve with the rating agencies, which is not that they are biased or even wrong, but that they are slow to react to changes on the ground. For those searching for an alternative, there is the sovereign credit default swap (CDS) market, where you can market assessments of default risk. The figure below summarizes the spreads for the roughly 80 countries, where they are available:

Sovereign CDS Spreads on June 30, 2024: Source: Bloomberg

Sovereign CDS spreads reflect the pluses and minuses of a market-based measure, adjusting quickly to changes on the ground in a country, but sometimes overshooting as markets overreact. As you can see, the sovereign CDS market views India as safer than suggested by the ratings agencies, and for the first time, in my tracking, as safer than China (Sovereign CDS for India is 0.83% and for China is 1.05%, as of June 30, 2024).

2. Country Risk Scores

    Ubiquitous as sovereign ratings are, they represent a narrow measure of country risk, focused entirely on default risk. Thus, much of the Middle East looks safe, from a default risk perspective, but there are clearly political and economic risks that are not being captured. One antidote is to use a risk score that brings in these missed risks, and while there are many services that provide these scores, I use the ones supplied by Political Risk Services (PRS). PRS uses twenty two variables to measure country risk, whey then capture with a country risk score, from 0 to 100, with the riskiest countries having the lowest scores and the safest countries, the highest:

Country risk scores in July 2024: Political Risk Services

While I appreciate the effort that goes into these scores, I have issues with some of the scoring, as I am sure that you do. For instance, I find it incomprehensible that Libya and the United States share roughly the same PRS score, and that Saudi Arabia is safer than much of Europe. That said, I have tried other country risk scoring services (the Economist, The World Bank) and I find myself disagreeing with individual country scoring there as well.

3. Equity Risk Premiums

    Looking at operations and investing, through the eyes of equity investors, the risk that you care about is the equity risk premium, a composite measure that you then incorporate into expected returns. I don't claim to have prescience or even the best approach for estimating these equity risk premiums, but I have consistently followed the same approach for the last three decades. I start with the sovereign ratings, if available, and estimate default spreads based upon these ratings, and I then scale up these ratings for the fact that equities are riskier than government bonds. I then add these country risk premiums to my estimate of the implied equity risk premium for the S&P 500, to arrive at equity risk premiums, by country. 

For countries which have no sovereign ratings, I start with the country risk score from PRS for that country, find other (rated) countries with similar PRS scores, and extrapolate their ratings-based equity risk premiums. The final picture, at least as I see it in 2024, for equity risk premiums is below:

Download spreadsheet

You will undoubtedly disagree with the equity risk premiums that I attach to at least some of the countries on this list, and perhaps strongly disagree with my estimate for your native country, but you should perhaps take issue with Moody's or PRS, if that is so.

Country Risk in Decision Making

    At this point, your reaction to this discussion might be "so what?", since you may see little use for these concepts in practice, either as a business or as an investor. In this section, I will argue that understanding equity risk premiums, and how they vary across geographies, can be critical in both business and personal investing.

Country Risk in Business

    Most corporate finance classes and textbooks leave students with the proposition that the right hurdle rate to use in assessing business investments is the cost of capital, but create a host of confusion about what exactly that cost of capital measures. Contrary to popular wisdom, the cost of capital to use when assessing investment quality has little to do with the cost of raising financing for a company and more to do with coming up with an opportunity cost, i.e., a rate of return that the company can generate on investments of equivalent risk. Thus defined, you can see that the cost of capital that a company uses for an investment should reflect both the business risk as well as where in the world that investment is located. For a multinational consumer product company, such as Coca Cola, the cost of capital used to assess the quality of a Brazilian beverage project should be very different from the cost of capital estimated for a German beverage project, even if both are estimated in US dollars. The picture below captures the ingredients that go into a hurdle rate:

Thus, in computing costs of equity and capital for its Brazil and German projects, Coca Cola will be drawing on the equity risk premiums for Brazil (7.87%) and Germany (4.11%), leading to higher hurdle rates for the former.

    The implications for multi-business, multi-national companies is that there is no one corporate cost of capital that can be used in assessing investments, since it will vary both across businesses and across geographies. A company in five businesses and ten geographies, with have fifty different costs of capital, and while you complaint may that this is too complicated, ignoring it and using one corporate cost of capital will lead you to cross subsidization, with the safest businesses and geographies subsidizing the riskiest.

Country Risk in Investing

    As investors, we invest in companies, not projects, with those companies often having exposures in many countries. While it is possible to value a company in pieces, by valuing each its operations in each country, the absence of information at the country level often leads us to valuing the entire company, and when doing so, the risk exposure for that company comes from where it operates, not where it does business. Thus, when computing its cost of equity, you should look not only at its businesss risk, but what parts of the world it operates in:

In intrinsic valuation, this will imply that a company with more of its operations in risky countries will be worth less than a company with equivalent earnings, growth and cash flows with operations in safer countries. Thus, rather than look at where a company is incorporated and traded, we should be looking at where it operates, both in terms of production and revenues; Nvidia is a company incorporated and traded in the United States, but as a chip designed almost entirely dependent on TSMC for its chip manufacture, it is exposed to China risk.

    It is true that most investors price companies, rather than value them, and use pricing metrics (PE ratios, EV to EBITDA) to judge cheap or expensive. If our assessment of country risk hold, we should expect to see variations in these pricing metrics across geographies. We computed EV to EBITDA multiples, based upon aggregate enterprise value and EBITDA, by country, in July 2024, and the results are captured in the figure below:

Source: Raw data from S&P Capital IQ

The results are mixed. While some of the riskiest parts of the world trade at low multiples of EBITDA, a significant part of Europe also does, including France and Norway. In fact, India trades at the highest multiple of EBITDA of any country in the world, representing how growth expectations can trump risk concerns. 

Currency Effects

    You may find it odd that I have spent so much of this post talking about country risk, without bringing up currencies, but that was not an oversight. It is true that riskier countries often have more volatile currencies that depreciate over time, but this more a symptom of country risk, than a cause. As I will argue in this section, currency choice affects your growth, cash flow and discount rate estimates, but ultimately should have no effect on intrinsic value.    

    If you value a company in US dollars, rather than Indian rupees, should the numbers in your valuation be different? Of course, but the reason for the differences lies in the fact that different currencies bring different inflation expectations with them, and the key is to stay consistent:

If expected inflation is lower in US dollars than in rupees, the cost of capital that you should obtain for a company in US dollars will be lower than the cost of capital in rupees, with the difference reflecting the expected inflation differential. However, since your cash flows will also then have to be in US dollars, the expected growth that you should use should reflect the lower inflation rate in dollars, and if you stay consistent in your inflation estimates, the effects should cancel out. This is not just theory, but common sense. Currency is a measurement mechanism, and to claim that a company is undervalued in one currency (say, the rupee) while claiming that it is overvalued at the same time in another currency (say, the US dollar) makes no sense. To practitioners who will counter with examples, where the value is different, when you switch currencies, my response is that there is a currency view (that the rupee is under or over priced relative to the dollar) in your valuation in your valuation, and that view should not be bundled together with your company story in a valuation.

    As we noted in the last section, the place that currency enters your valuation is in the riskfree rate, and if my assertion about expected inflation is right, variations in riskfree rates can be attributed entirely to difference in expected inflation. At the start of July 2024, for instance, I estimated the riskfree rates in every currency, using the US treasury bond rate as my dollar riskfree rate, and the differential inflation between the currency in question and the US dollar:

My estimates are in the appendix to this post. In the same vein, inflation also enters into expected exchange rate calculations:

This is, of course, the purchasing power parity theorem, and while currencies can deviate from this in the short term, it remains the best way to ensure that your currency views do not hijack your valuation.

YouTube Video

My Country risk premium paper

1. Country Risk: Determinants, Measures and Implications - The 2024 Edition

My Data Links

1. Equity risk premiums, by country - July 2024 (also includes ratings, PRS scores and sovereign CDS)
2. Riskfree rates in currencies, based upon differential inflation - July 2024

External Data Links

1. Democracy Index 2023, The Economist
2. Global Peace Index 2024: Source: Institute for Economics & Peace
3. Corruption Index 2023, Transparency International
4. International Property Rights Index 2023, Institute for Property Rights
5. Climate Risk Index 2021, ResourceWatch

Data Update 4 for 2022: Risk = Danger + Opportunity!

In the first few weeks of 2022, we have had repeated reminders from the market that risk never goes away for good, even in the most buoyant markets, and that when it returns, investors still seem to be surprised that it is there. Investors all talk about risk, but there seems to be little consensus on what it is, how it should be measured, and how it plays out in the short and long term. In this post, I will start with a working definition of riskt that we can get some degree of agreement about, and then look at multiple measures of risk, both at the company and country level. In closing, I will talk about some of the more dangerous delusions that undercut good risk taking.

What is risk?

In the four decades that I have been teaching finance, I have always started my discussion of risk with a Chinese symbols for crisis, as a combination of danger plus opportunity:

Over the decades, though, I have been corrected dozens of times on how the symbols should be written, with each correction being challenged by a new reader. That said, thinking about risk as a combination of danger and opportunity is both healthy and all encompassing. It also brings home some self-evident truths about risk that we all tend to forget:

1. Opportunity, without danger, is a delusion: If you seek out high returns (great opportunities), you have to be willing to live with risk (great danger). In fact, almost every investment scam in history, from the South Sea Bubble to Bernie Madoff, has offered investors the alluring combination of great opportunities with no or low danger, and induced by sweet talk, but made blind by greed, thousands have fallen prey. 
2. Danger, without opportunity, is foolhardy: In investing, taking on risk without an expectation of a reward is a road to ruin. If you are investing in a risky project or investment, your expected return should be higher to reflect that risk, even though fate may deliver actual returns that are worse than expected. Note that this common-sense statement leaves lots of details untouched, including how you measure risk and how you convert that risk measure into a higher "expected" or "required" return.
3. It is uncertainty about outcomes, not expected outcomes, that comprise risk: In investing, we often make the mistake of assuming that risk comes from expected bad outcomes, when it is uncertainty about this expectation that drives risk.  Let me use two illustrations to bring this home. In my last point on inflation, I noted that a currency with higher inflation can be expected to depreciate over time against a currency with lower inflation. That expected devaluation in the high-inflation currency is not risk, though, since it can and should be incorporated into your forecasts. It is uncertainty about whether and how much that devaluation will be, arising from shifting inflation expectations or market-induced noise, that is risk. In posts spread over many years, including this one, I have also argued against the notion that badly-managed firms are riskier than well-managed ones, and the reason is simple. If a firm is badly managed, and you expect it to remain badly managed, you can and should build in that expectation into your forecasts of that company's earnings and value. Thus, a badly managed firm, where you expect that to be the status quo, will be less risky than a well managed firm, where there is much more uncertainty about management turnover and quality in the future.
4. Risk is in the future, not the past: Risk is always about the future, since the past has already revealed its secrets. That said, many of our perspectives about, and measures of, risk come from looking backwards, using the variability and outcomes of past data as an indicator of risk in the future. That may be unavoidable, but we have to be clear that this practice is built on the presumption that there have been no structural changes in the process being examined, and even if true, that the estimates that come from the past are noisy predictors of the future. 
5. Upside versus Downside Risk: If risk comes from actual outcomes being different from expectations, it is worth noting that those outcomes can come in better than expected (upside) or worse than expected. Since the entire basis of investing in risky assets is to benefit from the upside, it is downside risk that worries us, and in keeping with this perspective, there have to been attempts to derive risk measures that focus only on or more on downside risk. Thus, rather than use the variance in earnings or stock prices as a measure of risk, you compute the semi-variance, drawing on those periods where earnings and returns are less than expected. I think a more sensible path is to measure all risk, upside and downside, and think of good investing as a process of finding investments that have more upside risk than downside risk.

As someone who works in, and teaches finance, I am grateful for what the discipline has done to advance the study of risk, but I would be remiss if I did not point out that it has come with some not-so-desirable side effects. One is the tunnel vision that comes from thinking of risk purely in terms of statistical measures, with standard deviation and variance leading the way. Risk is not an abstract statistical concept, but a feeling in the pit of your stomach that emerges when you helplessly watch your portfolio melting down, as markets move in the wrong direction. The other is the dangerous notion that measuring risk is the same as managing that risk and, in some cases, the even more insane view that it removes that risk.

Risk and Hurdle Rates

    In investing and corporate finance, we have no choice but to come up with measures of risk, flawed though they might be, that can be converted into numbers that drive decisions. In corporate finance, this takes the form of a hurdle rate, a minimum acceptable return on an investment, for it to be funded. In investing, it becomes a required return that you need to make an investment; you buy investments if you believe that you can make returns greater than their expected return and you sell investments if not. In this section, I will begin with a breakdown of risk's many components and use that structure to develop a framework for assessing the risk-adjusted required return on an investment.

The Components of Risk

    In any investment, there are multiple sources of risk, and listing all of them in a list, with no organization, can be not only overwhelming but directionless. Once you have identified the risks that you face, it is useful to break that risk down into categories, on three dimensions:

As you can see from this table, not all risk is created equal, and understanding which risks to incorporate into your required return, and which risks to ignore/pass through, is the first and perhaps the most important part of analyzing risk. While you will face almost every type of risk, no matter what company that you choose to value, the risks that you are most exposed to will vary across firms, and one way of looking at this variation is to look at firms through a corporate life cycle lens:

Note that you are more exposed to more risks, when you are looking at young companies, with growth potential, than when analyzing older, more mature firms, and that a greater proportion of risks at young companies are likely to be economic, micro and discrete risks. It is no wonder that investors and analysts who collect more and build bigger models, to value young companies, expecting that they will get better valuations, find frustrations instead. To get from these general risk categories into explicit risk measures and required returns, I adopt a simple structure (perhaps even simplistic), where I accept that I am a price taker when it comes to some risks (interest rates and risk premiums) and focus on the components of risk that companies can change through their choices on business, geography and debt load:

Note that in this structure, which yields costs of equity for companies and required returns for equity investors, each component is designed to carry a single burden, with the risk free rate reflecting the currency that you analyzing the company in, the measure of relative risk capturing the risk of the company's business mix and debt load, and the equity risk premium incorporating the risk of the geographies of its operations.

1. Relative Risk Measures

    Before we embark on how to measure relative risk, where there can be substantial disagreement, let me start with a statement on which there should be agreement. Not all stocks are equally risky, and some stocks are more risky than others, and the objective of a relative risk measure is to capture that relative risk. The disagreements rise in how to measure this relative risk, and risk and return models in finance have tried, with varying degrees of success, to come up with this measure. At the risk of provoking the ire of those who dislike portfolio theory, the most widely model for risk, in practice, is the capital asset pricing model, and beta is the relative risk measure. Embedded in its usage is the assumption that the marginal investors in a stock, i.e., those large investors who set prices with their trading, are diversified, and that you can estimate the "non-diversifiable" risk in a stock, by regressing returns on a stock against a market index. I believe that a company's regression beta is an extremely noisy measure of its risk, and mistrust the betas reported on estimation services for that reason. I also believe that it is healthier to estimate the beta for a company by looking at the average of the regression betas of the companies in the sector that it operates in, and adjusting for the financial leverage choices of the company, since increasing dependence on debt also increases the relative risk of the company. As in prior years, I report industry-average betas, cleaned up for debt, at this link, for US companies, and you can sector-average beta for regional and global companies as well. At the start of 2022, the ten sectors (US) with the highest and lowest relative risk (unlettered betas),  are shown below.

Download sector average betas (US, Global)

Note the preponderance of financial service firms on the lowest risk ranks, but note also that almost all of them are substantial borrowers, and end up with levered risk levels close to average (one) or above. Technology and cyclical companies dominate raw highest risk rankings.

2. Geographical Risk

Beta measure the macro risk exposure of the businesses that a company operates in, but they are blunt instruments, incapable of capturing either country risk (from operating in the riskiest parts of the world) or discrete risk (from default, nationalization or other events that truncate a company's life). For measuring country risk, I fall back on an approach that I have used for the last three decades to estimate equity risk premiums for countries, where I start with the equity risk premium for the US and then augment that number with a country risk premium, estimated from the default spread for the country:

The equity risk premium for the US is the implied equity risk premium of 4.24%, the process of estimating which I described in an earlier data update post this year. The sovereign ratings for countries are obtained from Moody's and S&P, and the default spread for each ratings class comes from my estimates for the start of 2022. To illustrate, at the start of 2022, India was rated Baa3 by Moody's and the default spread (my estimate) for this rating was 1.87%. I scale that default spread up to reflect the higher volatility in stocks, relative to bonds, and I use 1.16, estimated from as the ratio of historical volatilities in S&P's emerging market stock to the volatility in an emerging bond indices. This approach yields a country risk premium of 2.18% for India, and an equity risk premium of 6.42%, to start 2022:

India's ERP at the start of 2022 = Mature Market ERP + Default Spread for India * Rel Vol of Equity
                                                  = 4.24% + 1.87% (1.16) = 6.42%

Using this approach to the rest of the world, here is what I get at the start of 2022:

Download country equity risk premiums

It is worth emphasizing the equity risk premium for a company will come from where it operates in the world, not from its country of incorporation. Coca Cola, notwithstanding having its headquarters in Atlanta, has exposure to risk in multiple emerging markets, and its equity risk premium should reflect this exposure. By the same token, Embraer and TCS are global firms that happen to be incorporated in Brazil and India, respectively.

3. Debt, Default Risk and Hurdle Rates

    Almost all of the discussion so far has been about equity funding and its costs, but companies do raise funds from debt. While I will use a future post to talk about how debt levels changed in 2022, across the world, I want to talk about the cost of debt in this one. Specifically, the cost of debt for a company is the rate at which it can borrow money, long term, and today, and not the cost of the debt that is already on its books. The build up to a cost of debt is simple:

A company's default spread reflects concerns that lenders have about its capacity to meet its contractual commitments, and it clearly will be a function not only of the level and stability of its earnings, but even of the country in which it is incorporated.

    As companies raise money from both debt and equity, they face an overall cost of funding, which will reflect how much of each component they use, and the resulting number is the cost of capital. The picture below illustrates the linkages between the costs of equity and debt, and how as you borrow more, the effects on cost of capital are unpredictable, pushing it down initially as you replace more expensive equity with cheaper debt, but then pushing it up as the negative effects of debt offset its benefits:

Since both the costs of debt and equity start with the riskfree rate, low risk free rates push down both costs. In my last two posts, I noted that the prices of risk have drifted down in markets, with both equity risk premiums and default spreads decreasing through 2021. It should come as no surprise then that at the start of 2022, companies across the globe were looking at costs of capital that are close to their lowest levels, in US $ terms, in decades.

At the start of 2022, the median global company has a cost of capital of 6.33%, in US$ terms, and the median US company has a cost of capital of 5.77%. (To convert these values into other currencies, use the approach that I used in the last post, of adding differential inflation to the number).

Hurdle Rate Delusions

The two biggest forces that drive corporate financial and investor decision making are me-too-ism and inertia. The former (me-too-ism) leads companies to do what others in their peer group are doing, borrowing when they are, paying dividends because they do and even embarking on acquisitions to be part of the crowd. The latter (inertia) results in firms staying with policies and practices that worked for them in the past, on the presumption that they will continue to work in the future. Not surprisingly, both these forces play a role in how companies and investors set hurdle rates. Both individual investors and companies seem to operate under the delusion that hurdle rates should reflect what they want to make on investments, rather than what they need to make. The difference is illustrated every time an equity investor, in this market, posits that he or she will not buy shares in a company, unless he or she can make at least double digit returns, or a company, again in this market, contends that it uses a hurdle rate of 12% or 15%, in deciding whether to take projects. Individual investors who demand unrealistically high returns in a market that is priced to deliver 6-7% returns on stocks will end up holding cash, and many of them have been doing so for the bulk of the last decade. Companies that institute hurdle rates that are too high will be unable to find investments that can deliver higher returns, and will lose out to competitors who have more realistic hurdle rates. In short, companies and investors, demanding double digit returns, have to decide whether they want to remain delusional and be shut out of markets, or recalibrate their expectations to reflect the world we live in. 

YouTube Video

Datasets

1. Equity Risk Premiums, by country - January 1, 2022
2. Betas by Sector (US, Global, Emerging Markets, Europe, Japan)
3. Costs of Capital by Sector (US, Global, Emerging Markets, Europe, Japan)