Should you add basis points to adjust risk-free rates for volatility?

BVWireIssue #80-1
May 6, 2009

BVWire's™ inquiries—confirmed by BVR's teleconference last week on Developing Discount and Cap Rates in a Troubled Economy—indicate that the consensus answer is “no.” Don DeGrazia suggests that business appraisers should “not throw out the methods and empirical support we've tested over the many years.” It may be hard to justify breaking from these empirical methods to substitute some other long term proxy in the 4.5% range until the RFR returns to more historical norms, he believes.

Twenty-year Treasury notes, the most common proxy for the risk-free rate (RFR) in North America, are currently 200 basis points lower than historical levels (historical RFRs are available free from BVR). This factor by itself generates higher values, obviously, at a time when “reality” suggests values should be lower.

How should appraisers compensate for the fact that this key and trusted data source is currently producing counterintuitive valuations—by adding basis points? Co-presenter Stacy Preston Collins says, “We may become more dependent on industry research to help us justify lower earnings streams in the numerator of the value equation,” and because the industry-based elements of the discount rates may need to be adjusted upwards to compensate for higher risk.

DeGrazia, Collins, and Ron Seigneur agree that appraisers also need to pay more attention to measuring future income streams. “We're not only talking about the denominator [the discount rate], but also the numerator—the income stream—which is much less certain than it was in the past,” confirms DeGrazia.

“Every element of creating a discount rate is under examination now more closely than before,” says Collins. “A cookie-cutter approach to calculating discount rates won't stand up to scrutiny any longer.” Seigneur agrees: “We used to take the risk-free rate for granted, but now even that number is being questioned.”

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