Proxy for risk free rate in valuation and current state of interest rates

Proxy for future risk free rate was historically equal to rates of government bonds of countries with the best credit rating (assed by rating agencies like S&P, Moody’s or Fitch).

Nowadays in much of the developed world lenders are the ones paying for the privilege of letting governments borrow their cash. Through the magic of modern central banking, countries in Europe and elsewhere have managed to drive their borrowing rates not just to historic lows but all the way into negative territory (Read full story: The 5,000-Year Government Debt Bubble – http://www.wsj.com/articles/the-5-000-year-government-debt-bubble-1472685194).

Historically interest rates were (as presented in WSJ article) never negative, which poses a question if they are a short-term anomaly. When one has a goal to estimate the present value of the company, he/she needs to prepare a long-term projections of company’s operations. In accordance with that goal one must also estimate a discount rate, which will reflect the risk of long-term period.

As we previously presented in the article Risk free rate (available at http://p-s.com/news/risk-free-rate/ ), risk free rate is an important component of CAPM model, which is used in the process of estimating the value of companies.
When one estimates the risk free rate, he/she should differentiate between financial and non-financial companies.
When faced with the issue of estimating risk free rate for non-financial companies P&S CAPITAL estimates the risk free rate at the levels, which are expected by investors, which can be based on the historical normalized levels. You can read more about the risk free rate for the purpose of the valuation of non-financial companies here: http://p-s.com/news/risk-free-rate/

Risk free rate becomes somewhat more problematic when one is faced with the task of estimating such rate for financial companies (banks and insurance companies). Issue of risk free rates is important for the companies that generate returns in part by investing in bonds (for example insurance companies, which mostly hold government bonds in their portfolios). When one has to value returns from such assets issue of risk free rates once again comes up, especially when interest rates are near 0% or negative. For example if one would value German bond, which is also a proxy for risk free rate and in current state yields around 0%, but used a long-term estimated risk free rate (at around 3.5%), one would estimate that, an investor which would purchase such bond is losing money as soon as he/she would invest in the bond. In such case an appraiser must make a decision if he/she can use current levels of interest rate as a proxy for risk free rate (at least in short-term period).

Upper described issues are important when it comes to estimation of value and should be taken into account with the projects of business valuation.

You can read more about CAPM model drawback, which includes the issue of risk free rate, here: http://p-s.com/news/risk-free-rate/