Thursday, October 6, 2011

Damadoran on the current low risk free rate.

Aswath Damadoran has put together an excellent post on the current low risk free rate and the effect that it has on valuation.  His main point is that the risk free rate must be considered with the current expected risk premium.  When these are combined the result is relatively low valuations.   He also touches on another point which I'd like to emphasize.   In an equity valuation model we normally think of the risk free rate as only affecting the discount rate - so a lower risk free rate should result in a lower discount rate and thus a higher valuation.  But - and this is very important - the risk free rate also tells us a lot about the growth rate of the cash flows.  A low risk free rate implies low real growth and also low inflation.  Thus it will also reduce the level of future cash flows.  Failure to account for the two edges of the risk free sword is an example of inflation illusion.