Damodaran: can you trust your risk free rate?

"Last year I went from believing I could think through any valuation problem on September 12th, to thinking I didn't know the first thing about valuation by October 16th," Aswath Damodaran told the entire assembly at today's ASA Advanced Business Valuation Conference keynote speech.

"We got more than anything else a reminder of why we have an equity risk premium," he says.  "If you have a long term horizon, you'll always win on equities, and the ERP will eventually become zero."  But, we need the ERP to introduce risk.

What did Damodaran learn?   First, his beliefs prior to the crisis that were challenged included:

1.  Global investment provides diversification of risk--even though there was no safe haven in any index in the world

2.  Treasuries are riskless--even though during this period they actually dropped to zero.

3.  Shortterm borrowing markets would stay liquid--even though even GE could not write commercial paper on many days in this period

4.   Corporate bond default spreads would stay stable

So what did these new understandings contribute to the science of valuation?  Damodaran uses a case study of valuing the Brazilian company Embraer.  What is their risk free rate?  Would you use a 10-year US treasury bond of 3.5%, a 10-year nominal $R Braziliian government bond of 9.5%, the rate on the 10-year US dollar denominated Braiilian government bond is 6%, or the 10-year inflation indexed US treasury bond is at 1.5%?  

In fact, during the crisis, default risk on government bonds tripled.  In the euro, for instance, you have 12 countries issuing 10-year treasuries.   For a European valuation, you'd have to chose the lowest rate among the 12--since the higher rates all imply higher risk of default.  The US is triple A rated by Moody’s but if this changes, the 10-year bond rate will no longer be a “fact.  “It must be adjusted for the default spread, or you could be double counting risk.   For Embraer, in late 2008, the 10-year rate was 10.25 or so.  But, Brazil was Baa rated—not bad, but Moody’s estimates that has a 3% default spread.  So, the risk free rate would be 7.25%,” Damodaran argues.  If you don’t correct for this risk, you’ll “punish” Embraer for being Brazilian in the risk free rate, the beta, and the ERP.