Tue, May 12, 2020

Cost of Capital and Other Valuation Considerations in the Current Environment

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Executive Summary

The outbreak of the coronavirus (COVID-19) has generated an unprecedented reaction in both financial markets and real economy, and the resulting uncertainty highlights significant challenges for updating cash flow projections and estimating cost of capital inputs in the current environment. This article discusses adjustments that may be considered to both expected cash flows and their growth post-COVID-19, as well as the associated discount rates, as both impact valuation analyses based on discounted cash flow (DCF) methods. The Duff & Phelps recommended U.S. equity risk premium (ERP) was increased from 5.0% to 6.0%, effective March 25, 2020 as result of changes to economic and financial market conditions following the outbreak.

Anatomy of a Crisis – Where Are We Today?

On March 11, 2020, the World Health Organization (WHO) announced that it was changing its classification of COVID-19 to a “pandemic,” which meant the disease was spreading rapidly to different parts of the world.1 While China was the origin of the outbreak, Europe quickly became the most severely impacted. Meanwhile, on March 26, 2020, the U.S. became the country with the largest number of confirmed COVID-19 cases and on April 11, 2020, the country with the highest number of deaths.2 Figures are fluid, will vary depending on the source used and can significantly change on a daily basis.

Government social distancing policies implemented by several countries in response to COVID-19 have led to supply chain disruptions and the closure of many businesses and manufacturing facilities, harming business confidence. This has led to job losses in several industries, hurting consumer confidence. Healthcare facilities in some countries or geographic regions have been overwhelmed by the surge in COVID-19 patients while a meaningful cure to the disease, or vaccine to prevent the spread of the virus, are yet to be found at the time of writing.

Since their record highs reached in mid-February, global equity markets have collapsed at a speed faster than observed during the 2008 global financial crisis (GFC). For instance, between its record high on February 19, 2020 and the bottom reached on March 23, 2020, the S&P 500 index fell by 33.9% in just 33 days. Equity volatility, as measured by the VIX Index, reached a record high during that period. Corporate credit spreads surged, and major credit rating agencies have already downgraded numerous debt issuers. In addition, exacerbating the negative impact of COVID-19, global oil prices saw a major drop. The sharp reduction in oil prices was attributable at first to a price war between Saudi Arabia and Russia, which began on March 9, 2020 and continued until an agreement was reached on April 9, 2020. Economists have slashed real economic growth projections for 2020 and generally agree that the global economy is now in recession.

Major central banks have begun to implement quantitative easing and other crisis-related measures last employed during the GFC, as well as some new untested policies. Central bank actions also include interest rate cuts, which for some countries means that the benchmark policy rate is again near zero. Measures have been announced and implemented at a much faster pace than during, and in the aftermath of, the 2008 GFC. The “whatever it takes” approach by the Federal Reserve and the European Central Bank have helped stabilize global markets to a certain degree. Equity markets have recovered part of their losses and fixed income markets are functioning. However, the combination of these monetary policies, together with flight-to-quality flows towards government securities of countries considered “safe,” contributed to a significant decline in sovereign bond yields for these countries. Meanwhile, governments in some countries have already enacted or are in the process of approving sizable (and in some cases massive) fiscal stimulus packages.3

Impact of COVID-19 on Cash Flow Projections

The value of any investment is a function of three key inputs: (i) projected cash flows associated with the investment, (ii) expected growth in the projected cash flows and (iii) the required rate of return (or discount rate) to convert the cash flows into their present value.

To incorporate the incremental risk of COVID-19 in valuations, adjusting cash flow projections is the preferable approach to the alternative of adding ad-hoc risk premiums (i.e. alphas) to discount rates. The increased uncertainty of possible outcomes may best be captured by using a scenario-based analysis, which would entail estimating (i) the cash flows expected under each scenario and (ii) a probability factor associated with each of the scenarios.

Real Economic Growth Projections

In times of upheaval, when uncertainty is high, the range of economic estimates typically widens and can differ significantly among sources. The greater the uncertainty, the higher the variability around those projections. To assist in evaluating the impact of COVID-19 on expected cash flows, we assembled data on forecasted growth of real gross domestic product (GDP), as prepared by a variety of reputable sources, both before and after the COVID-19 outbreak. Real GDP growth projections issued in December 2019 and early January 2020 were compared to more recent forecasts released between March 1 and April 14, 2020. We focused on changes in the median projected real GDP growth for four geographies: (1) the world (or global) economy; (2) the United States; (3) the Eurozone; and (4) China.4

Exhibit 1: Real GDP (Median) Estimates for 2020 and 2021 Before and After the Coronavirus Outbreak (in percentage terms), with Data Updated through April 14, 2020

*Calculated as the simple difference between real GDP growth before and after the outbreak of COVID-19. For instance, the decline in the 2020 real GDP growth estimates of 4.7% for the World Economy is based on the difference between -2.1% after COVID-19 and the 2.6% before COVID-19.
**Calculated as the relative change in real GDP growth before and after the outbreak of COVID-19. For instance, the relative decline of 182% for the World Economy’s 2020 real GDP growth estimates is based on the ratio of the revised -2.1% estimate (after COVID-19) over the original 2.6% prior to the outbreak

The current discussion among economists is no longer whether a recession will take place due to the impact of COVID-19, but which shape the recovery will take. While there is no formal definition of recovery patterns, the following summarizes the shapes more commonly used to describe economic/business cycles:

  • V-shaped: This is a best-case scenario when the economy bounces back to pre-recession levels as rapidly and as sharply as it fell. In the context of COVID-19, this would mean that demand lost during a nationwide lockdown would simply be deferred to a later date, with the pace of economic activity recovering to levels seen before the outbreak. 
  • U-shaped: This is a recession that may begin with a somewhat slower decline in economic activity than in a V-shaped recovery, but then remains at the bottom for an extended period of time before growth starts climbing back up. 
  • W-shaped: This type of recession will initially resemble a V-shaped recession, but is followed by a setback, with economic activity seeing another downturn, after having shown signs of recovery. A second wave of COVID-19 outbreaks could lead to a W-shaped (a.k.a, “double-dip”) recession.
  • L-shaped: The most concerning of shapes, because it means that once the economy plunges, it stays down for a significantly long time. Japan’s “lost decade” in the 1990s is often given as an example of an L-shaped recovery.

For the U.S., the views have become increasingly gloomier since early March, with very few still anticipating a V-shape recovery. Recovery patterns following a U, L or even W shape (if the virus returns in full force in the fall of 2020) are all considered plausible.5 In the Eurozone, it is clear that economists do not anticipate the recovery in 2021 to offset the loss in economic output projected for 2020. Meanwhile, China is the more likely case to follow a V-shaped recovery. The economic recovery patterns will clearly vary by country, geographic region and industry.

Ultimately, our view is that the intensity of this shock and subsequent recovery will be determined by a number of factors, including: (1) the underlying virus properties (e.g., rate of transmission, whether it mutates and returns for a second wave of contagion, etc.); (2) the speed in development and approval of effective antiviral medicines and vaccines that can help “flatten” the curve for both death and infection rates; (3) monetary and fiscal measures that assist in mitigating the economic impact of the crisis; (4) health-related and other policy responses that prevent the spread of the virus and/or support healthcare facilities treating coronavirus patients; and (5) consumer behavior and corporate decisions in the face of this uncertainty.

Corporate Earnings Growth Projections

Adjusting company-level projections in the current environment can be a daunting task. The greater the uncertainty of the possible paths of economic recovery, the more difficult it is to model earnings projections. Because of this heightened level of uncertainty, it becomes ever more important to (i) review various data sources that reflect a range of plausible outcomes and (ii) develop different scenarios and associated probabilities for the different recovery outcomes.

Besides the overall economic backdrop, the industry environment will influence how well a company will perform in the next couple of years. With several companies forced to reduce capacity, or close their business activity altogether, due to social distancing policies, analysts have been making numerous and substantial cuts to earnings estimates for various global stock market indices.

To assist in the development of a base case scenario, we gathered recent consensus estimates of revenues and total earnings (i.e. net income) for the S&P 500 and the STOXX Europe 600. We then reviewed the most impacted industries within these indices. The following are some highlights from an industry perspective:

  • S&P 500 Index: There is quite a disparate range in the growth rates of earnings estimates by industry sectors. According FactSet, Energy is by far the most affected industry, given the double impact of COVID-19 and the collapse in oil prices. Conversely, Information Technology appears to be the least impacted industry, even though earnings estimates are lower than they were back at December 31, 2019.6
  • STOXX Europe 600 Index: According to Refinitiv, the decline in the STOXX Europe 600 earnings is expected to be double the rate for the S&P 500.On the other hand, the dispersion between industry growth rates is not as wide as forecasted for the S&P 500, although still sizable. Energy is also the most affected industry in Europe, by a large margin. In contrast, Utilities is expected to be the industry least impacted in European markets.


Impact of COVID-19 on Cost of Capital Inputs

The preceding sections contained data updated close to the time of writing (mid-April). The following discussion regarding risk-free rate and equity risk premium (ERP) is based on data collected proximate to March 23, 2020.

Risk-Free Rate

Spot Risk-Free Rates versus Normalized Risk-Free Rates: Beginning with the 2008 GFC, valuation analysts have reexamined whether the “spot” risk-free rate is still a reliable building block upon which to base their cost of equity capital estimates. The GFC challenged long-accepted practices and highlighted potential problems of using the spot yield-to-maturity on a safe government security as the risk-free rate, without any further adjustments.

During periods in which risk-free rates appear to be abnormally low due to flight-to-quality or massive central bank monetary interventions, valuation analysts may want to consider normalizing the risk-free rate. By “normalization” we mean estimating a risk-free rate that more likely reflects the sustainable average return on long-term U.S. government bonds.

Material distortions to spot government debt yields can occur during periods characterized by significant flight-to-quality investment flows or by central bank monetary policies that entail significant intervention in sovereign debt securities markets and/or the implementation of negative interest rate policies. These actions may (i) distort long-term yields by reducing term premiums that no longer reflect market expectations of long-term inflation; and even (ii) drive short-term real yields to negative levels (i.e., below 0.0%), which will no longer reflect the time value of money, and implicitly assumes that the real rate of growth for the overall economy will be negative.

Methods of Estimating a Normalized Risk-Free Rate: Estimating a normalized risk-free rate can be accomplished in a few ways, including (i) simple averaging, and (ii) various “build-up” methods.

The first method of estimating a normalized risk-free rate entails calculating averages of yields to maturity on long-term government securities over various periods. This method’s implied assumption is that government bond yields revert to the mean. An issue with using historical averages, though, is selecting an appropriate comparison period that can be used as a reasonable proxy for the future.

The second method of estimating a normalized risk-free rate entails using a simple build-up method, where the components of the risk-free rate are estimated and then added together. Conceptually, the risk-free rate can be (loosely) illustrated as the return on the following two components:8

Risk Free = Real Rate + Expected Inflation


In Exhibit 2, we summarize long-term real rate estimates and inflation expectations for the U.S. as of March 23, 2020, based on data assembled from a variety of sources.9 The long-term real rate estimate of 0.0% to 2.0% is based on a compilation of various academic research papers. For comparison purposes, the spot rate as of March 23, 2020 was 1.1%, while the 120-month (i.e., 10-year) trailing average of 20-Year U.S. government bonds was 2.8%. Based on this analysis, Duff & Phelps concluded on a normalized U.S. risk free rate of 3.0%.

Exhibit 2: Long-Term Spot and Normalized Risk-Free Rates for the U.S. as of March 23, 2020 (approximately)

Duff & Phelps Recommended U.S. ERP

The ERP is a key input used to calculate the cost of capital within the context of the Capital Asset Pricing Model (or CAPM) and other models. Duff & Phelps regularly reviews fluctuations in global economic and financial market conditions that may warrant a reassessment of the ERP.

In Exhibit 3, we list the primary factors considered when arriving at the Duff & Phelps recommended U.S. ERP. We document the evolution of these factors from December 31, 2019, along with the corresponding relative impact on ERP indications.

At 2019 year-end, the Duff & Phelps U.S. Equity Risk Premium recommendation was 5.0%. At that time, risk levels were perceived to be low and equity markets in the U.S. reached all-time highs. In early December of 2019, two major global events had been resolved favorably, contributing to investor optimism: 

  • The uncertainty related to an ongoing trade war between U.S. and China was significantly reduced when both countries reached the phase 1 of a trade agreement; and
  • British parliamentary elections gave a clear majority to the Conservative Party, allowing Brexit to proceed.

Since then, economic and financial market conditions have changed dramatically. Based on current conditions illustrated in Exhibit 3, we found sufficient evidence for increasing the Duff & Phelps U.S. ERP recommendation from 5.0% to 6.0% for valuation dates as of March 25, 2020 and thereafter. We will maintain our recommendation to use a 6.0% U.S. ERP until there is evidence indicating equity risk in financial markets has materially changed. We continue to closely monitor the economic outlook and financial market conditions. While financial markets have recovered some of the losses suffered through the March lows, the uncertainty and underlying risk caused by COVID-19 is still very elevated.

Exhibit 3: Factors Considered in the U.S. ERP Recommendation: Relative Changes from December 31, 2019 to March 23, 2020

The current ERP recommendation was developed in conjunction with a “normalized” 20-year yield on U.S. government bonds as a proxy for the risk-free rate. The combination of the new U.S. recommended ERP (6.0%) and the reaffirmed normalized risk-free rate (3.0%) results in an implied U.S. “base” cost of equity capital estimate of 9.0% (6.0% + 3.0%).

Adjustments to the ERP or to the risk-free rate are, in principle, a response to the same underlying concerns and should result in broadly similar costs of capital. Adjusting the risk-free rate in conjunction with the ERP is only one of the alternatives available when estimating the cost of equity capital. For example, you used the spot yield-to-maturity of 1.1% on 20-year U.S. Treasuries as of March 23, 2020, you would have to increase the ERP assumption accordingly. An ERP estimate inferred by the Duff & Phelps recommended U.S. ERP (used in conjunction with the normalized risk-free rate), can be determined against the spot 20-year yield as of March 23, 2020 by using the following formula:

U.S. ERP Against Spot 20-Year Yield (Inferred) =

= Duff & Phelps Recommended U.S. ERP + Normalized Risk-Free Rate – Spot 20-year U.S. Treasury Yield

= 6.0% + 3.0% – 1.1% = 7.9%

On April 16, 2020, Duff & Phelps held a webcast titled "Coronavirus: Cost of Capital Considerations in the Current Environment", which discussed many of the concepts outlined in this article in greater detail. Visit https://www.duffandphelps.com/cpe-webcasts to watch a replay.

Duff & Phelps is the leading global independent valuation services firm and a trusted expert on estimating cost of capital. For over 20 years, our professionals have published books, created studies, provided recommendations and built tools to help businesses and valuation professionals calculate cost of capital. The Duff & Phelps Cost of Capital Navigator is an online platform that guides you through the process of estimating cost of capital. Visit dpcostofcapital.com to learn more.


1.World Health Organization, “WHO Director-General’s opening remarks at the media briefing on COVID-19”, March 11, 2020, available here: https://www.who.int/dg/speeches/detail/who-director-general-s-opening-remarks-at-the-media-briefing-on-covid-19---11-march-2020.
2.Feuer, William, Noah Higgins-Dunn, Berkeley Lovelace Jr., “US now has more coronavirus cases than either China or Italy”, CNBC, March 26, 2020. CNBC.com, https://www.cnbc.com/2020/03/26/usa-now-has-more-coronavirus-cases-than-either-china-or-italy.html. See also, Levitz, Jennifer, Mike Cherney and Daniel Michaels, “U.S. Coronavirus Death Toll Passes Italy, Becoming World’s Highest”, Wall Street Journal, April 11, 2020. WSJ.com, https://www.wsj.com/articles/health-officials-plead-for-public-to-observe-a-locked-down-easter-11586592822.
3.The International Monetary Fund (IMF) created a Policy Tracker tool that summarizes the key economic responses governments are taking to limit the human and economic impact of the COVID-19 for over 190 economies. This includes both monetary policy and fiscal measures and can found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.
4.Sources: OECD, IMF, Blue Chip Economic Indicators, Consensus Economics, Economist Intelligence Unit (EIU), Fitch Ratings, IHS Markit, Moody's Analytics, Oxford Economics, S&P Global Ratings.
5.For an evolution of the discussions on this topic, see for example: (1) Pisani, Bob, “Wall Street bulls and bears fight over what the economic recovery from coronavirus will look like”, CNBC, March 5, 2020, CNCB.com, https://www.cnbc.com/2020/03/05/wall-street-bulls-and-bears-fight-over-what-the-recovery-will-look-like.html; (2) Marte, Jonnelle, “Coronavirus shifts U.S. recession debate from 'if' to 'what shape'?, Reuters, March 11, 2020, Reuters.com, https://www.reuters.com/article/us-health-coronavirus-usa-recession/coronavirus-shifts-u-s-recession-debate-from-if-to-what-shape-idUSKBN20Y33B; (3) Hansen, Sarah, “The Great Depression Vs. Coronavirus Recession: 3 Metrics That Will Determine How Much Worse It Can Get”, Forbes, March 24, 2020, Forbes.com, https://www.forbes.com/sites/sarahhansen/2020/03/24/the-great-depression-vs-coronavirus-recession-3-metrics-that-will-determine-how-much-worse-it-can-get/#d378bae15bd2; (4) Carlsson-Szlezak, Philipp, Martin Reeves and Paul Swartz, “Understanding the Economic Shock of Coronavirus”, Harvard Business Review, March 27, 2020, hbr.org, https://hbr.org/2020/03/understanding-the-economic-shock-of-coronavirus; (5) Barone, Robert, “Economy/Markets: SNAFU – The Shape Of The Recovery”, Forbes, March 28, 2020, Forbes.com, https://www.forbes.com/sites/greatspeculations/2020/03/28/economymarkets-snafu--the-shape-of-the-recovery/#7543b36466d5; (6) Winck, Ben, “The recession alphabet: How analysts are using letters to project the economy's recovery from coronavirus “, Business Insider, March 29, 2020, businessinsider.com, https://www.businessinsider.com/recession-recovery-coronavirus-alphabet-letter-shape-project-economic-when-analysts-2020-3; (7) Holland, Ben, “Economists Are Losing Hope in a ‘V-Shaped’ Post-Virus Recovery”, Bloomberg, March 31, 2020, Bloomberg.com, https://www.bloo mberg.com/news/articles/2020-03-31/a-quick-rebound-from-virus-economists-have-reason-to-doubt-it.
6.Butters , John, “Earnings Insight,” FactSet, April 3, 2020, Insight.Factset.com, https://insight.factset.com/sp-500-records-8th-largest-quarterly-decline-in-eps-estimate-since-2002-for-q1.
7.Dhillon, Tajinder “STOXX 600 Earnings Outlook”, Refinitiv, April 7, 2020, lipperalpha.refinitiv.com, https://lipperalpha.refinitiv.com/2020/04/stoxx-600-earnings-outlook-17q1/2.
8.This is a simplified version of the “Fisher equation”, named after Irving Fisher. Fisher’s “The Theory of Interest” was first published by Macmillan (New York), in 1930.
9.Sources of long-term inflation expectations: The Livingston Survey, dated December 13, 2019; Survey of Professional Forecasters, First Quarter 2020 (February 14, 2020); Cleveland Federal Reserve’s Inflation Expectations, released March 2020; Blue Chip Financial Forecasts dated December 1, 2010 and March 1, 2020; Blue Chip Economic Indicators, dated March 10, 2020; Consensus Economics, December 2019 and March 2020, Philadelphia Federal Reserve, Aruoba Term Structure of Inflation, February 2020; the University of Michigan Inflation Expectations, March 2020.

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