Valuation Across Time
Valuing all companies becomes more complicated in an unsettled macroeconomic environment. In fact, three basic inputs into every valuation—the risk-free rate, risk premiums, and overall economic growth (real and nominal)—can be volatile in some cases, making it difficult to value any company. In this section, we will look at the reasons for volatility in these fundamental inputs and how they can affect valuations.
To value a risky asset, we have to answer a fundamental question: What can you expect to earn as a rate of return on a riskless investment? The answer to this question is the risk-free rate. Although we take it as a given in most valuations, it can sometimes be difficult to identify. When the risk-free rate is unknown, everything else in the valuation is open to question as well.
To understand why estimating the risk-free rate can be problematic, let us define a risk-free rate. It is the rate of return you can expect to make on an investment with a guaranteed return. For an investment to deliver such a return, it must have no default risk, which is why we use government bond rates as risk-free rates. In addition, the notion of a risk-free rate must be tied to your time horizon as an investor. The guaranteed return for a six-month investment can be very different from the guaranteed return over the next five years.
So, what are the potential issues? The first is that, with some currencies, the governments involved either do not issue bonds in those currencies, or the bonds are not traded. This makes it impossible to get a long-term bond rate in the first place. The second issue is that not all governments are default-free, and the potential for default can inflate the rates on bonds issues by these entities, thus making the observed interest rates not risk-free. The third issue is that the riskless rate today may be (or may seem to be) abnormally high or low, relative to fundamentals or history. This leaves open the question of whether we should be locking in these rates for the long term in a valuation.
Market Risk Premiums
When valuing individual companies, we draw on market prices for risk for at least two inputs and make them part of every valuation. The first is the equity risk premium. This is the additional return that we assume investors demand for investing in risky assets (equities) as a class, relative to the risk-free rate. In practice, this number is usually obtained by looking at long periods of historical data, with the implicit assumption that future premiums will converge to this number sooner rather than later. The second input is the default spread for risky debt, an input into the cost of debt in valuation. This number is usually obtained by either looking at the spreads on corporate bonds in different ratings classes or looking at the interest rates a company is paying on the debt it has on its books right now.
In most valuations, the equity risk premium and default spread are assumed to be either known or a given. Therefore, analysts focus on company-specific inputs—cash flows, growth, and risk—to arrive at an estimate of value. Furthermore, we usually assume that the market prices for risk in both equity and debt markets remain stable over time. In emerging markets, these assumptions are difficult to sustain. Even in mature markets, we face two dangers. The first is that economic shocks can change equity risk premiums and default spreads significantly. If the risk premiums that we use to value companies do not reflect these changes, we risk undervaluing or overvaluing all companies (depending on whether risk premiums have increased or decreased). The second danger is that there are conditions, especially in volatile markets, where the equity risk premium that we estimate for the near term (the next year or two) will be different from the equity risk premium that we believe will hold in the long term (after year 5, for instance). To get realistic valuations of companies, we have to incorporate these expected changes into the estimates we use for future years.
The Macro Environment
It is impossible to value a company without making assumptions about the overall economy in which it operates. Since instability in the economy feeds into volatility in company earnings and cash flows, it is easier to value companies in mature economies, where inflation and real growth are stable. Most of the changes in company value over time, then, come from changes in company-specific inputs. We face a very different challenge when we value companies in economies that are in flux, because changes in the macroeconomic environment can dramatically change values for all companies.
In practice, three general macro economic inputs influence value. The first is the growth in the real economy. Changes in that growth rate will affect the growth rates (and values) of all companies, but the effect will be largest for cyclical companies. The second is expected inflation; as inflation becomes volatile, company values can be affected in both positive and negative ways. Companies that can pass through the higher inflation to their customers will be less affected than companies without pricing power. All companies can be affected by how accounting and tax laws deal with inflation. The third and related variable is exchange rates. When converting cash flows from one currency into another, we have to make assumptions about expected exchange rates in the future.
We face several dangers when valuing companies in volatile economies. The first is that we fail to consider expected changes in macroeconomic variables when making forecasts. Using today's exchange rate to convert cash flows in the future, from one currency to another, is an example. The second danger is that we make assumptions about changes in macroeconomic variables that are internally inconsistent. Assuming that inflation in the local currency will increase while also assuming that the currency will become stronger over time is an example. The third danger is that the assumptions we make about macroeconomic changes are inconsistent with other inputs we use in the valuation. For instance, assuming that inflation will increase over time, pushing up expected cash flows, while the risk-free rate remains unchanged, will result in an overvaluation of the company.