One of the quiet but extremely problematic developments in finance over the last decade has been a small factor in discounted cash flow model valuations that has been so impactful that it’s led many in the industry to abandon this form of valuation entirely in favor of alternatives.
The DCF or discounted cash flow is a standard method of valuing an asset based upon the cash that it generates. Taught in beginning finance classes and as part of the CFA level 1 exam, the DCF is known as the plain vanilla bare bones method of evaluating the value of an asset, and it serves as the starting point for any hedge fund, mutual fund, or investment bank.
Since it depends on an existent cash flow, it isn’t as popular in the high tech venture capital world, where companies earning little to no cash get multi-million dollar valuations. But one of the alarming developments since interest rates plummeted in 2009-2010 is that the DCF model has lost traction in traditional finance as well. As a result, analysts have been looking for alternative methods to evaluate assets, which has introduced tremendous risk and uncertainty into the financial world.
The reason is simple: interest rates. The backbone of the DCF model is its comparison of the asset’s cash flow to a risk-free rate of return, which is used to calculate the asset’s rate of return using the WACC formula. That rate of return, r, is then established as a benchmark to evaluate an investment’s value.
An alternative to using the risk-free rate of return is to use an expected rate of return for assets of similar risk. So, for instance, if you’re looking to invest in a mid-cap tech company you would expect a 14% rate of return over 10 years because that’s what mid-cap tech companies gave over the last 10 years. There are obviously a lot of problems with this method of evaluation, which is why it was much less popular than using a risk-free rate to calculate r. And that option has been disappearing since the risk-free rate has fallen so very low.
Why is this a problem? Because with an incredibly low risk-free rate of return, the WACC calculation makes riskier assets more attractive as a result of the lower hurdle needed. For example, if the risk-free rate is 5% and the risky investment opportunity returns 10%, the DCF analysis could give (for instance) a valuation of $10.00 per share. But the same analysis with a 2% risk-free rate would give a valuation of a much, much higher share price—in this example, in the ballpark of about $70.
If we’re applying the DCF valuation method to this tech stock and it’s currently trading at $20 in a high interest-rate environment, we’d say that it’s 50% overvalued. But in the new low-rate environment, it’s suddenly absurdly cheap.
But the massive variation in our results is not the result of anything about the tech company itself—it’s all a result of the risk-free rate we are assuming. Which tells us that the DCF valuation method on its own cannot work anymore.
While many different analysts have developed different alternatives to approach this problem, the core issue is that it is in fact a problem—and it’s one that investors and analysts will need to keep taking seriously if interest rates never actually do rise again.