A 1993 survey conducted among 100 US firms on the Fortune 500 found that 90% of them used a unique discount rate to value their investment plans, regardless of the activity involved, and that only 35% employed different division-level discount rates; and yet, we are taught at MBA school and university that discount rates should depend on risk!
Choosing a unique rate is quick and simple and serves to avoid any discussions about the correct percentage to be applied. But what impact does this practice have on investments that are not carried out because they are (incorrectly) considered unpromising? What is the impact on investments that were thought to be profitable but ultimately destroy firm value?
Valuation methods influence investments
Thesmar, Landier and Kruger measured the impact of the discount rate choice by examining the investment decisions of US conglomerates and comparing them with those made by firms operating in a single business segment. The result is asymmetric. In conglomerates, the non-core divisions involved in safer industries suffer from under-investment linked to the high discount rate selected by the parent company, which artificially reduces the value of their projects. The opposite, however, is not true: corporations whose core activity is relatively protected from market shocks do not tend to over-invest in their riskier affiliates.
Definition of discounted cash flow (DCF)
Discounted cash flow analysis is a method of determining the current value (i.e., today’s value) of future cash flow. DCF analysis makes it possible, inter alia, to calculate the value of investment projects over different periods so that they can be compared. A project’s discount rate also corresponds to the minimum rate of return below which an investment is considered unprofitable.
The danger of overpaying for an acquisition
The second phase of the research was devoted to analyzing the cost of pricing acquisitions incorrectly. Targeting acquisitions has the advantage that it concerns large-scale investment projects (with comprehensive data), and therefore valuation mistakes are likely to affect the acquirer’s value. The researchers observed the stock price reaction for the purchaser after the announcement of the acquisition.
The data shows once more that the markets react negatively to the news of a deal made by a bidder from a safe sector (hence with a low discount rate) in a risky sector (with a high discount rate). The markets “understand” that such acquirers tend to “overpay” for their targets.
The study found that an over-valued acquisition generates an average loss of 0.7 % of the bidder’s market equity, and approximately 7% of the value of the purchased company. On the scale of the US market, this represents losses of billions of dollars due to mistakes in valuation.
An over-valued acquisition generates an average loss of 0.7 % of the bidder’s market equity, and approximately 7% of the value of the purchased company.
The outcome of investment decisions depends on their context
The researchers discovered an interesting phenomenon: valuation mistakes have diminished over time. While there were significant errors in the 1980s, they fell to the point that they barely registered in the 2000s. This shows that the good practices taught in MBA schools are being increasingly applied!
The study undertaken by Thesmar, Landier and Kruger also shows that the higher the potential cost of a miscalculation, the more likely it will be avoided, as large acquisition projects are scrutinized by an investment bank. And when an investment project relates to a secondary business line that has an important role in a corporation’s global value, finance departments provide the means to implement an appropriate discount rate.
This is also the case when conglomerate firms are highly diversified or when the head of a firm holds more than 1% of the capital. It would appear that company heads take greater care to surround themselves with competent financial managers, in such a way that any miscalculations that ultimately remain are more and more marginal, and apply to projects with the smallest impact on the firm. This kind of behavior is consistent with what economists call “bounded rationality”: individuals and organizations have a limited ability to manage cognitive errors, and it is the most costly mistakes that are prioritized.