Consideration of Economic Risks in a Valuation Practice: Journey from the Kingdom of Tradition to the Kingdom of Common Sense

Abstract

Many of those who regularly utilize discount rates in various economic estimates often do not seem to make an inquiry as to their veritable functions they are intended to serve, but rather focus merely on utilitarian aspects of their impact on value: "discount rate ↓ - value ↑" or "discount rate ↑ - value ↓". However, a discount rate - is not an artificial technical construct for the "fitting" of value or plugging in gaps devoid of any economic sense. It is piteous that because of an array of 'generally recognized' economic and mathematical attire imposed on them, discount rates have become of such technical nature, in the process, losing out their original economic meaning. Valuers and analysts continue with the perseverance that would do credit to medieval alchemists to use the 'magical' formulas of the built-up method, CAPM and the like discount rate structures adjusted for risk. All this does not fall short of a material misconception in the real state of things, be it though of a pervasive nature, and serves to discredit the very standing of the Valuation Profession.

Further slide down this ladder of practice might deal a heavy blow to the entire institution of Professional Valuation and compromise the public trust in the way it happened with the auditors in the wake of a scandalous Enron and Worldcom bankruptcies and the tragic 'demise' of Arthur Andersen.

Keywords: Value, Discount Rate, Risk, Opportunity Cost, Inflation, DCF, NPV, CCF, Income Approach, Valuation, Investment Analysis, Risk Management, Finance, Innovation