Roger Gabrowski: “Cost of capital went down because the risk free rate went down”.
On Tuesday, 7th of October 2014, Roger Grabowski, a leading world authority on cost of capital in valuation of businesses and real estate, shared his rich experience in business valuation with participants of the seminar. In the last 30 years, he held executive positions in Standard&Poor’s, PricewaterhouseCoopers and Duff&Phelps. The seminar was organized by Faculty of Economics and Slovenian Institute of Auditors.
Roger Grabowski introduced the participants of the seminar to the most controversial issues and problems in estimating the cost of capital, after the financial crisis in 2008. In his opinion, traditional methods typically employed in estimating the cost of equity capital (COEC) and the weighted average cost of capital (WACC) are subject to significant estimation and data input problems. He stressed that U.S. Treasury bond (T-bond) yields, the typical benchmark used in the Capital Asset Pricing Model (CAPM), were low for several months in 2008, resulting in unreasonably low estimates of COEC. In his opinion, the expected equity risk premium (ERP) has likely increased as stock market indices have declined . Interestingly he pointed out that the correction of the stock market’s valuations for the financial services sector and in highly leveraged companies, exposes flaws in commonly-employed methods used for estimating betas. This has led to faulty estimates of risk for non-financial and companies with little debt. »Current leverage ratios are not sustainable in the long-term for many companies and one needs to consider estimating cost of capital to take into account expected changes in comapanies’ capital structures. Because income subject to income taxes is and will continue to be less than zero for many companies, one cannot automatically use an after-tax cost of debt capital in calculating an appropriate WACC«.
Gabrowski emphasised that main message of his seminar is that there is no simple formula that can be used in all circumstances. ”There is no model which will give all the answers as theory expected. You have to use a lot of models for estimating the cost of capital if you want to get the right forecast“. He believes that since 2007, risk free rate has lost its meaning as an estimator of what inflation expectations are. ”This is the result of central bank intervention. They have pushed long term interest rates down, much lower than they should be. Cost of capital went down because the risk free rate went down”.
From his point of view the reason for the huge indebtedness of the private sector in Slovenia lies in underestimation of the impact of downside risk. ”Companies are always optimistic when they are making projections; this is the nature of entrepreneurs. The biggest issue is that people are not recognizing that company can underperform. This is why people are not paying much attention to analysing risks in business environment”. As regards the situation of the Slovenian economy, especially the highly deleveraged corporate sector, he urged authorities to conduct privatization. »You have to accept that the value of many of your businesses is very low and therefore it is better to get foreign investors. They will buy them and will bring real equity capital which will strengthen the liquidity and capitalization of the corporate sector. Slovenia also needs a more competitive economy, this can be achieved through privatization. Slovenia should follow the positive examples in other countries which made structural changes to their economies«.
Grega Umek, EFnews
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