In mid-September 2008, Professor Aswath Damodaran (NYU Stern School of Business) believed “I could think through any valuation problem.” By the end of October, he told last week’s ASA Advanced Business Valuation Conference, during his two-hour keynote address, “I didn't know the first thing about valuation…the current economy reminds us why we have an equity risk premium.”
The financial crisis challenged many of Damodaran’s longstanding beliefs, including:
1. Global investment provides diversification of risk. By year-end, there was no safe haven in any index in the world.
2. Treasury bonds are riskless. During the downturn they actually dropped to zero.
3. Short-term borrowing markets stay liquid. Even GE could not write commercial paper.
4. Corporate bond default spreads would stay stable. Enough said.
Recent economic events require rethinking of valuation fundamentals—even the risk-free rate. In a case study, Damodaran valued the Brazilian company Embraer, and asked ASA attendees what they would select for its risk-free rate: a 10-year U.S. Treasury bond (3.5%); a 10-year nominal $R Brazilian government bond (9.5%); the 10-year U.S. dollar denominated Brazilian government bond (6%); or the 10-year inflation-indexed U.S. T-bond (1.5%)?
In fact, during the crisis, default risk on government bonds tripled. Moody’s still gives the U.S. a AAA rating, but if this changes then the 10-year U.S. T-bond rate will no longer be an effective default risk-free rate. Damodaran said “it must be adjusted for the default spread or you could be double counting risk.” In late 2008, the 10-year rate was approximately 10.25% for Embraer. Brazil was Baa rated—but Moody’s estimated a 3% default spread. So the risk-free rate would be 7.25%, he concluded. If you don’t correct for this risk, “you’d punish Embraer for being Brazilian in the risk-free rate, the beta, and the ERP.
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