Implications of low risk free rates on valuations
At the end of 2011 the risk free rate tumbled down to a new all-time low of 2,42%. The unstable situation on financial markets has been steadily fueled by the political instability arising from the ongoing European sovereign debt crisis. Hence, investors lost trust in the markets and are therefore on the search for safer investments. This drives the price of considerably safe investments and thus leads to decreases in effective rates.
As the risk free rate constitutes a fundamental part of the discount rate used for valuations, its development takes effect on the value of businesses and other assets. The end of the year, December 31, is by nature a commonly used valuation date – many business valuations and impairment tests are typically performed on that date. Therefore, the very low risk free rate of this year’s end can be expected to be widely applied. All else equal, a lower risk free rate leads to lower discount rates, which, in turn, lead to higher valuation results. Considering only the direct effects of the risk free rate and ignoring other possibly adverse effects that might go along with a low risk free rate, one would wind up with an inconsistent valuation and unnaturally high values.
As a result, valuation professionals should, amongst other things, specifically pay attention to the consistency of the planning assumptions with the applied discount rate, the determination and level of the market risk premium, or the assumptions regarding the sustainable growth rate.
From a simplified perspective, the nominal risk free rate can be seen as the sum of the “real” risk free rate plus the expected inflation rate. Assuming that the real risk free rate is more or less stable over time, the observed, nominal risk free rate somehow reflects people’s view on the economic future. A low nominal risk free rate implies inflation and real growth expectations at low levels. Hence, these relationships should be considered when analyzing a business plan or determining a sustainable growth rate. Apart from that, the initially described “flight to quality” – the investor’s search for safer investments – also affects, besides the risk free rate, the risk premiums for risky asset clas-ses. Therefore, the equity risk premium can be expected to rise.
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