VALUATION THEORY
Chepakovich Valuation Model Valuation Basics Valuation of Banks Intrinsic Value
Intrinsic Value
Introduction Cash Flows Risk-Free Rate Assesment of Risk
Assessment of certainty of future cash flows
Now, that we determined the risk-free rate, we only need to know the probability of default in order to come up with an appropriate discount rate for each investment.
It all comes down to the basic concept of risk in any financial investment: what is the likelihood that for whatever reason we will not be paid? In the case of investment in common shares, we need to asses the risk of not receiving the future cash flows we count on receiving (directly, indirectly or by the way of accrual).
Bankers have a special term for non-payment – 'default'. To each client they assign a credit rating, which is directly related to the probability of default. Credit rating agencies go even further: they rate not just individual companies, but also individual debt instruments. One can find statistics showing historic default rates for each rating's category.
Of course, no one knows the future, and, therefore, no one knows what default rates in each rating's category will be, but at least there is some methodology in place to differentiate the risk of default. By the way, this methodology is not very reliable and not scientific at all. To this day, assigning credit ratings is as much a science as it is an art.
OK. We have the methodology to assign a credit rating to the company. Then, using historical rates of default, we can estimate the probability of default. But this is for debt. What do we do if we plan to invest in equity? We argue that the process in this case is not that much different: if the company defaults on its debt, we, as equity investors, for sure are not going to get anything. On the other hand, however, the company can fail to produce all the cash flow we projected but still produce enough of it to service its debt. Therefore, while the rating methodology might be the same, we need to assign a higher probability of default on cash flow to equity to each rating, than historical data suggests assigning to debt.
One very important innovation introduced by the Chepakovich valuation model is the use of different discount rates for each period in the future. This logically follows from the fact that the probability of default increases with increase in the time horizon.