The Ibbotson data for 2008 are now available. As we knew but can now quantify definitively, the risk-free rate and the equity risk premium are both down. This means that other things (the industry risk premium and the specific company equity risk premium) being equal, equity cash flow discount rates are lower.
This has several important implications.
First, for businesses that expect to grow and earn higher cash flows, lower discount rates mean higher equity values.
Second, the specific company equity risk premium (if unchanged) will be a higher proportion of the total (lower) discount rate. This makes it even more important not to proclaim this premium without proof. We have to do the best we can, based on company analysis, to justify its magnitude. We also have to be honest about the uncertainty associated with estimating it.
Third, lower discount rates make them more sensitive valuation assumptions for a given set of forecast cash flows. Calculate this for yourself. Check the percentage differences between discounted cash flow values for rates of 15 versus 17% and 10 versus 12%, just to pick values at random. Both discount rate sets differ by 2%, but the valuation differential between 10 and 12% is a lot greater than that between 15 and 17%.
Nobody said business valuation is easy…recent market developments have made it even harder!