How flawed is the risk-free rate for current valuations?

BVWire–UKIssue #20-1
November 3, 2020

When valuers are expected to supply a DCF analysis (an increasingly frequent need), most start with the risk assumption of a market premium compared to government bonds. As Pablo Fernandez reminds us in his latest publication:

[T]he market risk premium (MRP or ERP) is the answer to the following question: Knowing that your money invested in long-term Government bonds will provide you a return of RF% almost for sure, which additional return you require to another investment (in a portfolio with shares of most of the companies with shares traded in the financial markets) for feeling compensated for the extra risk that you assume?

In 'Normalized' Risk-Free Rate: Fiction or Science Fiction? however, Fernandez questions whether the valuation profession is causing itself some problems when valuers ‘fix’ the risk-free rate (which is near zero or even negative) when the current rate doesn’t create an accurate valuation.

He provides evidence with a model DCF analysis of a hypothetical large consulting and financial services firm (some UK business valuers may think they recognize Duff & Phelps as the model).

Fernandez identifies four cases where the ‘invented’ RfR creates an obvious fiction:

‘1) it does not exist: we cannot invest in any financial instrument and get the “Normalized Risk-Free rate” without (or with little) risk;

‘2) in several cases it is higher than the cost of debt;

‘3) in several cases it is higher than the required return to debt;

‘4) most valuations do not adjust the value of Debt accordingly to the “Normalized Risk-Free rate” they use.’

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