Valuation: The Risk Free Rate

Now that we’ve introduced ourselves to the concept of Valuation and reviewed the idea of Intrinsic Valuation yesterday, we’re finally at the point we move into deriving a discount rate. Just like the term “Intrinsic Value” the concept of the “Discount Rate” is tossed around in finance/investing circles like a hot potato: everyone seems to mention how important it is, but are opaque about just how you go about deriving one. You’ve heard Warren Buffett proclaim that the intrinsic value of an asset is the cash flow that an asset will generate between now and Judgement Day, discounted back to the present at an appropriate discount rate. While this is all fine and dandy, it’s never revealed to us mere mortals what the discount rate is. I think these next few sections on Valuation in the coming days might shed light on that for you. Today, we focus on one component of the discount rate: the Risk Free Rate.

I won’t spend too much time here because there is a simple answer to what to use as the Risk Free Rate. Damodaran uses the 10 Year US Treasury yield as his Risk Free Rate and the video will explain why that is. I lean towards agreeing with him and will use the 10 Year US Treasury yield as a default Risk Free Rate unless there is some reason to reconsider it.

The not so simple answer to the Risk Free Rate is that if your company is based outside the US (i.e. an emerging market) or it is a US company that derives significant revenue from outside the US, you will have to tweak your Risk Free Rate to account for the additional risk.

The basic idea of this is to look up the country’s credit rating and if it is not AAA, get the default spread between the non-AAA rating and the AAA rating and subtract that spread from the country’s 10 year bond rate.

I’d suggest delving into the video above and the lecture slides to get a better idea of how to tweak for the Risk Free Rate if you are not going to be using the 10 Year US Treasury bond.

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