That’s what Gary Trugman (Trugman Valuation Associates) wondered after reading the lead item in last week’s BVWire about the potential downgrading of U.S. debt, now an economic (and emotional) reality. His response:
Although I agree wholeheartedly with Roger Grabowski, the question raised is much more fundamental. I am seeing valuation analysts plug risk-free rates into a build-up or CAPM model without considering whether the answer, as opposed to the components of the model, makes sense. It seems that the business valuation community has lost sight of what a discount rate really is. A discount rate is the required rate of return that is necessary given the risk of the projected benefit stream from the subject investment. This means that the BV analyst should be looking for comparable investment vehicles, and their yields, with a similar set of future return risks as those from the interests at issue.
It doesn’t matter which component of the discount rate you’re discussing, because if it does not reflect the expected future return, the answer will be wrong. We can get very technical about this discussion but it is time to keep it simple (K.I.S.S.) and remember that the total discount rate is what we are after and not just a single component.
Regardless, the Principle of Substitution tells us that we should be looking for an alternative investment in the market with similar risk characteristics to use as a surrogate in determining the required rate of return in the subject investment at the valuation date. This is valuation theory 101.
What the credit downgrade means for your cost of capital analysis: On Tuesday, August 16 BVR welcomes Ron Seigneur (Seigneur Gustafson) and Don DeGrazia (Gold Gocial Gernstein) for a special one-hour webinar, “Credit Ratings & Debt Ceilings: How will Recent Actions by the S&P and Federal Government Affect Business Valuation?” Learn what the experts are saying about the recent market volatility—and earn CPE, too.