Business valuation and risk-free rate of return

Risk and return go hand in hand in valuation of any business asset. When an investor puts money into a business there is expectation of being paid at some future point in time. However, the investor faces the risk both of losing the investment and foregoing a better opportunity somewhere else.

So how can you go about selecting what return is good enough for an investment in a particular business? Let’s say you want to compare companies across a broad economic spectrum. Then you would need a way to calculate reasonable returns given the risk each company represents.

Safe investment in risk-free assets

At the center of such decision making is the concept of a risk-free rate of return. This represents the income you could earn by simply putting your money into an asset that pays a known amount at regular intervals. In addition, you are guaranteed to get your investment back in full at a fixed point of time in the future. In short, you face no risk of default, hence the investment is risk-free.

Imagine that a borrower can convince investors that their money is safe. Then all other investments must demonstrate higher returns to attract money away from the risk-free asset. The question each investor asks is why put money into a business rather than keeping it in the risk-free asset?

Extra returns for taking more investment risk

Because you can earn higher returns by taking additional risks. As long as a risk-free investment opportunity exists, you can put just a small portion of your available capital into a company that may earn you quite a bit more money. If the investment doesn’t pan out, most of your capital is still safe sitting in that risk-free investment, earning steady income. But if the company succeeds, you would enjoy a nice premium for taking the extra risk.

Government bond yields – the gold standard of risk-free return

Typical risk-free assets are government backed bonds, such as the US Treasury bonds. In fact, business appraisers use the yields on long-term Treasurys as the gold standard for calculating the risk-free rate of return. The risk of a company investment includes a number of risk premia. That helps you come up with how much higher the return for a given company ought to be for you to bet your money on it.

This is a really nice and elegant way to figure out if a company is worth investing in. All you need to do is calculate the required rate of return and see if the company has demonstrated that it can achieve this. If so, you can make an informed decision to put some money into it and and rest confident that you have made a prudent investment choice.

What if there is no risk-free investment?

But what happens if the risk-free return disappears from the market? Let’s say the government fails to repay its bonds or make payments on its obligations to the investors?

Now the part of your investment you thought of as risk-free no longer exists. Worse yet, you have no way of calculating how much higher the returns should be on any other investment you may consider. The neat framework of calculating investment returns and comparing businesses before making a call goes out the window.

The result is investor panic. When investors see no way of keeping their money safe, in risk-free investments, they take off for the exits. If no investment is assured, the proverbial mattress becomes the safest place. Even the bank vault won’t do as banks can default on their obligations leaving their customers high and dry.

Moral: investor confidence is critical to business investment

This lack of faith in a default investment is devastating to the market. In a sense, the values of all assets are eroded if no risk-free investment can be found. Most investors are conservative by their nature and need the assurance of a safe haven they can retreat to in times of uncertainty. In other words, the market players need to see a gold standard that is immune to market forces to measure the value of business investments.

See Valuation Tour