Factor Current Risks Into the Cost of Capital
Estimating discount rates is a complex task — even in the best of times. But today’s uncertain economy has forced valuation experts to re-evaluate traditional methods of quantifying discount rates. Discount rates take into account the time value of money. These rates may be used when valuing a business under the income approach or as a “hurdle” rate when evaluating capital budgeting decisions.
Equity vs. WACC
Equity investors and lenders require a certain “return” to compensate them for letting borrowers use their money. The level of return depends on the perceived risk of the investment. In general, a high-risk investment requires a high return, which equates with a low price.
In today’s volatile marketplace, what return do equity investors and creditors expect? Business valuation experts ask this question when they quantify the discount rate (also known as the cost of capital). The discount rate may be based on either:
- The cost of equity, or
- The blended cost of debt and equity capital, sometimes known as the weighted average cost of capital (WACC).
Experts may use the cost of equity as a discount rate or as a key component of the WACC, depending on the income stream being discounted (equity or invested capital).
Sources of Empirical Data
Building up the cost of equity usually starts with estimating the risk-free rate. Long-term Treasury bond rates — which are commonly used to estimate this rate — have dropped significantly compared to historic rates.
Equity risk premiums are another key component of the cost of equity. When estimating the cost of equity, valuation experts can refer to several data sources, including Duff & Phelps and Morningstar. Moreover, they can refine the data — by size and industry code, for example — to obtain a more comparable sample. In today’s markets, public stock prices have fallen because the perceived risk has increased, and investors are demanding higher returns. Some experts advocate using current rates of return over historic long-term rates.
Another component of the WACC is the cost of debt. Though the costs of business loans are currently near historical lows, there are generally fewer tax breaks for using debt financing. In prior years, experts factored a “tax shield” into their cost of debt to reflect the deductibility of business interest expense. However, current tax law limits deductions for business interest expense for larger businesses. Plus, distressed companies generally don’t generate taxable income, so there’s little if any current tax benefit to paying interest.
Furthermore, in today’s distressed economic conditions, a company’s access to capital may be limited. This may affect its capital structure in the future. When sources of borrowing are limited, shareholders may be asked to contribute additional funds or forgo distributions to help keep the business afloat. To the extent that a company relies more on equity financing and less on debt financing, its weighted average cost of capital will increase.
Word of Caution
Valuation is said to be a “prophecy” of the future. While no one can predict the future with 100% accuracy, detailed market and industry research can help support discount rates. The COVID-19 crisis has had a material negative effect on many businesses. This being the case, historic performance may not always be a reliable predictor of future performance.
A company’s historic cost of capital may need to be adjusted to reflect current market conditions. When factoring financial distress into the valuation equation, it’s important to avoid double-counting risk factors when quantifying the discount rate and elsewhere in their calculations (such as when they quantify earnings streams and marketability discounts). An experienced valuation professional can estimate a discount rate that’s based on detailed market and industry research.