Home > Articles > Business & Management > Finance & Investing

  • Print
  • + Share This
This chapter is from the book

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.

Interest Rates

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.

  • + Share This
  • 🔖 Save To Your Account

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020