Hurdle rates
There are two parties involved in the allocation of capital both into and within public companies – the investor and the manager. Do your return requirements align with the managers of the companies you’re invested in?
Investors typically value a company by discounting the future cash flows at a required return, such as the Weighted Average Cost of Capital (WACC). If debt and equity is used to fund an investment, then its expected return should exceed the weighted average of the funding costs. If not, it’s probably best that the funds are returned or given to someone who can.
As world interest rates have fallen to record lows, we have witnessed many financial analysts lower their required returns, lifting company valuations. Many investors have also been unimpressed with returns on bank deposits, and have supplemented their income with dividend yield. Lower return requirements in both scenarios have justified higher share prices.
One should naturally think that the required return, or “hurdle rate”, that managers use to make investment decisions should also have fallen with interest rates. But research presented by the Reserve Bank of Australia (RBA) and the Federal Reserve indicate this may not be so.
In a recent RBA note, Lane and Rosewell (2015) considered that hurdle rates used by liaison contacts are not changed very often and in some instances have not been altered for several years.
The Federal Reserve has also referenced research published by Sharpe and Suarez (2013) who reported that the majority of surveyed CFOs would likely not change their investment plans in response to a decrease in interest rates.
This has important implications. While investors have pushed share prices higher on expectations that companies will continue investing above the cost of capital, management of the company may not have reduced the internal return benchmarks just because capital is cheaper to access.
If you have entered into an investment where the management’s required return exceeds your own, you must carefully consider the additional risk of capital loss you have exposure to. At Montgomery, we consider that the return expectations of the two parties will converge over the long term, and have not lowered the discount rate we use to value companies during this unique period.
Ben MacNevin is an Analyst with Montgomery Investment Management. To invest with Montgomery, find out more.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Patrick Poke
:
While I agree with you in principal, how exactly does one define the ‘normal’ risk-free-rate? If you look at 5, 10, 20 and 50 year averages, for say, US t-bills or t-bonds, you’d get different results over every period. Rates rose through the 60s and 70s before peaking in 81, and have been on a fairly steady downwards course since. I remember a comment from Aswath Damodaran on his blog that was something along the lines of ‘you can tell how long an analyst has been in the business by what they think is a ‘normal’ risk-free rate’.
Ben MacNevin
:
Hi Patrick. Investing isn’t an exact science, so one cannot define a ‘normal’ risk free rate. Historical data series certainly play a role in determining discount rates, but keep in mind what the risk free rate reflects – what return do I require assuming no risk of loss. Ultimately it is a decision for the individual investor, rather than something with a definitive “right” answer.
Kelvin Ng
:
Thanks Ben. Yes, for investors to lower their discount rate in valuing companies, they must view the current record low rates as permanent, when in fact interest rates may turn out to be mean reverting.
Kelvin
Greg McLennan
:
Yes, you’d be assuming that interest rates had reached ‘a permanently low plateau’.