Risk-Free Rate During the Economic Downturn

Business Advisors|Business Valuation

By Dan Riske

The yield on U.S. treasury securities has long been a standard proxy for the risk-free rate in cost of equity calculations for business valuation. However, Standard and Poor’s recent downgrade of the U.S. credit rating from “AAA” to “AA+” could change the once-accepted notion that U.S. treasury securities closely resemble risk-free assets.

Although valuation analysts have never assumed that U.S. credit risk is equal to zero, it was previously small enough to closely resemble a risk-free asset. Prior to 2009, five-year credit default swaps (“CDS”) for U.S. treasuries, which can be purchased to eliminate credit risk, were priced at approximately 0.10% to 0.15% of the price of the security, which was considered immaterial to its yield. Today, a CDS can be purchased for approximately 0.50%, which is not necessarily immaterial, especially considering the fact that the yield on U.S. treasuries has declined since 2009.

Given these changes, the question arises of whether or not U.S. debt can still be used to determine a risk-free rate, and if not, what other risk-free rate proxies are available? Possible alternative proxies do exist; however, each of these has inherent issues that would require potentially subjective adjustments to estimate the risk-free rate. It is also important to note that the two remaining top credit rating agencies, Moody’s Investor Service and Fitch, have not downgraded their “AAA” rating for the U.S.

While there is currently no clear solution to finding a more accurate risk-free rate, Roger Grabowski, a managing director of Duff & Phelps’ Chicago office and co-author of numerous valuation books, provides one possible alternative. During times of economic struggle (such as the present) when the treasury rate is highly volatile, Mr. Grabowski suggests that instead of using the 20-year spot yield on government treasuries, a longer-term average would be more appropriate. He also posits that analysts should adjust the risk-free rate by looking at the real rate of interest and inflation estimates.

Michael Goldman, principal of his own valuation practice and member of The Value Examiner Editorial Board, believes that a more accurate cost of equity calculation would include analyzing the rates of return expected by investors in the marketplace and the given level of risk that those investors are willing to assume. Although this type of information is not readily available at this time, this information could be submitted to transaction databases, such as Pratt’s Stats, along with the currently reported multiples and statistics.

© 2011 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

You’ve heard our thoughts… We’d like to hear yours

The Schneider Downs Our Thoughts On blog exists to create a dialogue on issues that are important to organizations and individuals. While we enjoy sharing our ideas and insights, we’re especially interested in what you may have to say. If you have a question or a comment about this article – or any article from the Our Thoughts On blog – we hope you’ll share it with us. After all, a dialogue is an exchange of ideas, and we’d like to hear from you. Email us at contactSD@schneiderdowns.com.

Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

© 2019 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.