“Should we lower or increase our discount rate when valuing these assets?” asked the timberland investor, worried about impacts from the coronavirus (COVID-19) on trade, U.S. economic growth and asset values.
Generally, discount rates represent the sum of a benchmark “risk-free” rate and a risk “premium.” The risk premium may be viewed as comprised of two parts: firm or asset class-specific risk (diversifiable) and market risk (affects all investments). For example, the Southern Pine Beatle is an asset risk specific to timber, while economic recessions take no prisoners and affect all sectors. For timberland, 30-year U.S. Treasuries often serve as the risk-free rate.
The investor then asked, “wouldn’t I be better off using a long-term average U.S. Treasury rate, closer to 3%, to reflect normal times or higher inflation rates for my risk-free rate?”
Short answer: No.
Long answer: U.S. Treasuries and the risk-free rate represent your baseline opportunity cost. You can deploy uninvested capital in existing U.S. Treasuries, not into bonds earning hypothetical, historical ten, twenty or thirty-year average yields. Sorry, Charlie.
But let’s talk about other implications and what you can do. Over nearly twenty years of teaching finance classes and workshops, I always discuss with students the importance of spending the marginal minute on confirming, testing and strengthening our understanding of potential cash flows over fine tuning the discount rate in discounted cash flow (DCF) analysis.
During times of crisis or concern, like those associated with the coronavirus, DCF values and potential returns get affected by (1) changes in the benchmark risk-free rate and (2) by the premium that investors require above this rate to hold timberland, stocks or other assets. Jittery investors lead to higher risk premiums and lower Treasury rates. Investors often flee to bonds when worried. Increased demand leads to higher bond prices and lower bond yields.
What do bond markets tell us? First, we have historically low risk-free rates. As of today (February 26th), the 30-year Treasury yields 1.81%. And the yield curve inverted, with one-month treasuries now yielding 1.59% versus 1.14% for the 5-year bond. Are people worried? Yes. Yields have fallen 13.4% over the past two weeks. Perhaps counterintuitively, a low risk-free rate expresses market pessimism and concern rather than economic health, stability and the potential for rapid growth.
Tweaking and theorizing over the appropriate discount rate, like checking email, provides a false sense of productivity and control. Nailing down, to the extent possible, our expected costs and revenues creates more value and addresses directly our key assumptions.
Click here to learn about and register for “Applied Forest Finance” on March 19th in Atlanta, Georgia. The course details necessary skills and common errors associated with the financial analysis of timberland and other forestry-related investments, including the use of discount rates.