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This article was originally published in BVWire Issue #166-2
Brexit reinforces need for consistency in cost of capital
Leading global valuation experts and finance professors chimed in on the impact of the Brexit vote on cost of capital during a recent webcast from Duff & Phelps. One message they all stressed is to maintain internal consistency between the elements of cost of capital and the current economic environment. Also, you need to consider that there may be a “new normal” in terms of interest rates, risk premiums, and growth.
Just another crisis: Brexit is simply a “garden variety” crisis similar to others over the past five years, such as the crises in China, Russia, and Greece, according to Aswath Damodaran (New York University Stern School of Business). To treat Brexit differently is a “mistake,” he says. Rather than thinking about the effects of Brexit separately on the three basic elements of valuation (cash flow, growth rate, and discount rate), valuators should instead focus on being internally consistent. He points out that a crisis such as this “muddies the waters” for all three elements, but, if you’re consistent with the way you deal with Brexit with all of the three ingredients, your mistakes will “tend to average out.” If you’re not consistent, that’s “when you get into trouble.”
Speakers Elroy Dimson (Judge Business School, University of Cambridge) and Pablo Fernández (University of Navarra—IESE Business School in Spain) agreed with the idea of consistency. Webinar host Roger J. Grabowski (Duff & Phelps) also agreed and stressed that matching the cash flows to your expectations and the consistency of those expectations with the economic environment are a critical element of your valuation. This includes a consideration that long-term growth may be much lower going forward in the U.S., U.K., and the eurozone than what may have been expected before. “Maybe we are in a ‘new normal,’ with lower interest rates, higher risk premiums and slower growth,” says Grabowski. “It’s something for all of us to consider as we do our valuations.”
No change to U.S. ERP: Duff & Phelps regularly reviews fluctuations in global economic and financial conditions that warrant periodic reassessments of the equity risk premium (ERP) used for developing discount rates. Earlier this year, D&P increased its recommended U.S. ERP to 5.5% for use as of Jan. 31, 2016, and thereafter. This implies a 9.5% (4.0% + 5.5%) “base” U.S. cost of equity capital estimate as of Jan. 31, 2016. During the webcast, Grabowski stated that the preliminary indication as of June 30 is that there is “no change in our recommended ERP” in the U.S. He points out that the risks associated with the China slowdown and now Brexit “come and go” and are “not significant enough” to warrant a change at this point.
The speakers, who also included Yann Magnan, European valuations leader at Duff & Phelps, offer a great deal more insight into the impact of Brexit on the cost of capital.
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