On Friday evening, the S&P downgraded the United States’ sovereign debt rating to AA+ for the first time in our history. While we all saw yesterday what a huge impact this downgrade could have on our stock portfolios, there is also a considerable effect on the process by which we as valuation practitioners value closely-held companies. For years, valuators have based their analyses of cost of capital on the assumption that the U.S. debt is “risk-free.” For example, our firm typically uses the 20-year U.S. Treasury bill rate as an indicator of the risk-free rate, and the remaining analysis of our cost of capital estimates is driven off of this underlying assumption. So, telling valuators that now U.S. credits are not truly without risk is sort of like telling a little kid that there’s no Santa Claus. It flies in the face of a very fundamental assumption that we have relied upon for years and years.
But let’s be realistic, the fact that there is some default risk on U.S. debt is not a terribly new phenomenon. The downgrade itself only formalizes the reality that there is (and was, for some time) risk of default on U.S. credits. Just like Santa Claus never existing, the U.S. debt was never truly risk-free (at least in the very recent past). So, what are valuators to do? As Aswath Damodaran points out in a recent blog posting, the risk-free rate will need to be estimated rather than simply relying on Treasury bill rates. Because there is some risk of default built in to the rate of return of Treasury notes (presumably the market anticipated and understood that there was risk of default, and therefore such notes are priced accordingly), some practitioners recommend adjusting the Treasury bill rate downward by a default spread. Intuitively, this makes sense – if there is some risk built into the rates we observe, then we would need to back out the portion of the rate that relates to default risk to arrive at a truly “risk-free” rate. Other ideas have been tossed about on LinkedIn discussions, and there is also an upcoming webinar from BVR to discuss the matter.
All of this means that we will likely have one more area of subjectivity in our valuation work. Thankfully, most valuation practitioners are very comfortable by now in the inexactitudes that come with doing this sort of work, so we should be well situated to navigate this new challenge.
Wondering how the risk-free rate will affect your business's value? Post a comment below or contact our Business Valuation Services at 440-449-6800.