Critical ingredient in discounted cash flow valuation. Errors in estimating the discount rate or mismatching cash flows and discount rates can lead to serious errors in valuation. At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cash-flow being discounted. If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. The currency in which the cash flows are estimated should also be the currency in which the discount rate is estimated. If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the discount rate should be nominal.
The cost of equity should be higher for riskier investments and lower for safer investments.While risk is usually defined in terms of the variance of actual returns around an expected return, risk and return models in finance assume that the risk that should be rewarded (and thus built into the discount rate) in valuation should
be the risk perceived by the marginal investor in the investment. Most risk and return models in finance also assume that the marginal investor is well diversified, and that the only risk that he or she perceives in an
investment is risk that cannot be diversified away (I.e, market or non-diversifiable risk).
There are various models to calculate cost of Equity, however the most popular one being CAPM
Consider the standard approach to estimating cost of equity:
Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)
where,
Rf = Riskfree rate
E(Rm) = Expected Return on the Market Index (Diversified Portfolio)
In practice, Short term government security rates are used as risk free rates, Historical risk premiums are used for the risk premium & Betas are estimated by regressing stock returns against market returns.
On a risk-free asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return. For an investment to be riskfree, then, it has to have a) No default risk b) No reinvestment risk. Thus, the riskfree rates in valuation will depend upon when the cash flow is expected to occur and will vary across time. In valuation, the time horizon is generally infinite, leading to the conclusion
that a long-term riskfree rate will always be preferable to a short term rate, if you have to pick one.
But what happens in a situation like that in Greece, where there is no riskfree/default free assest to be found, how do we then estimate a Riskfree Rate when there are no default free entities.
-Approach 1: Subtract default spread from local government bond rate: Government bond rate in local currency terms - Default spread for Government in local currency.
-Approach 2: Use forward rates and the riskless rate in an index currency (say Euros or dollars) to estimate the riskless rate in the local currency.
Do the analysis in real terms (rather than nominal terms) using a real riskfree rate, which can be obtained in one of two ways –
• from an inflation-indexed government bond, if one exists
• set equal, approximately, to the long term real growth rate of the economy in which the valuation is being done.
Do the analysis in a currency where you can get a riskfree rate, say US dollars.
