The risk free rate is one of the basic inputs used for company valuation. I have done a bit of thinking on the risk free rate because it poses a number of practical challenges faced by analysts.
For example, when risk free rates are extremely high or extremely low (e.g. government bond yields are fairly low across South Asia at the moment) do we take the current yield or a historical average? If we take an average will it be a 3 year or a 5 year average? In fairly volatile times, the answers to these questions can have pretty large implication for stock valuation.
For the purpose of this post, my focus is more on currency risk. For an investor investing in frontier markets the weakness of the local currency versus his home currency (which is usually USD) can erode the value of his investment. So once we decide a fair value of a company in its local currency do we need to adjust for potential currency depreciation? The short answer to that question is yes, but only under certain circumstances. And that is exactly why investors get scared when they expect a major currency depreciation in a particular country.
But let us rewind for a bit. Lets start with the risk free rate. Why is it that the risk free rate in one country is higher than another country’s even though they are both supposed to be risk free? The explanation for that is that both countries have different inflation expectations. Real risk free rates are supposed to be similar across countries and thus the difference in the nominal risk free rates are caused by only differences in inflation. Now, according to the PPP theory, the long term currency depreciation of one country can be calculated by long term differences in inflation. That means that the risk of future currency depreciation (in a normal situation) is already embedded in the risk free rate (and thus also the discount rates). And if it is embedded we don’t need to adjust the intrinsic value of the company again for currency depreciation.
Wait a minute!!! Didn’t I just say that under certain situations, we DO have to adjust? That particular situation is when a currency is significantly over or undervalued (is in a big disequilibrium). In certain times, currencies in certain countries are grossly overvalued and under a free market mechanism would depreciate. In such situations, the risk free rate differential (aka the inflation differential) would not fully incorporate the currency risk and we need to adjust our estimates of fair values further for the one big depreciation expected to come.
Let us take the example of Nigeria which a lot of people think will see a depreciation of 30-50% (the range is quite wide). Assuming we fall in the more optimistic group and believe in a 30% depreciation. For our valuation purpose, we can value the company using the cost of capital calculated from the local risk free rate and then adjust our value further by an extra 30%.