The Cost of Indian Capital.
How to adjust hurdle rates for valuing businesses in India.
Imagine your nephew comes to you on a hot Sunday afternoon. He wants to open a new grocery store in your locality and asks for a loan. You know he is honest, but you also know three other shops nearby failed last year. How much interest do you charge him to sleep peacefully at night?
Every business promise is about the future. A company promises to pay you profits five or ten years from now. But a rupee in your hand today is always worth more than a rupee promised tomorrow. To compare them, you need a tool to shrink that future rupee down to its present value. We call this the discount rate.
If you put money in a government bank, you expect a safe, low return. But when you buy a private business, you take on real risk. The store might shut down, or the industry might change. You must demand a higher return to cover this extra risk. This minimum return is your hurdle rate.
In India, calculating this hurdle rate has a catch. Our government bonds offer higher interest than US bonds, but they also carry a tiny risk of default. Professor Aswath Damodaran teaches us to strip away this country risk first. Only then do we add the specific risk of the stock market and the individual company to find the true cost of equity.
Gold Rate and Making Charges
Think of valuing a company like buying gold jewellery. When you go to the store, there is a standard rate for raw, pure gold. That is your risk-free base. But the jeweller also charges you making charges for the design, which varies based on how complex the ornament is. In investing, the risk-free rate is your pure gold rate. The equity risk premium and the company's beta are the making charges. You cannot pay only the gold rate for a finished necklace, just as you cannot demand the risk-free rate for a volatile business.
Why this matters
If you set your hurdle rate too low, you will make poor businesses look like great bargains. You will end up buying stocks that destroy your savings. But if you set it too high, you will miss out on wonderful companies. Getting this number right is the shield that protects your hard-earned wealth.
Where people go wrong
- Using 10-year bond yields directlyThe 10-year Indian Government Bond yield contains country default risk and is not purely risk-free like US Treasuries.
- Applying US risk premiums to IndiaIndian markets are more volatile than mature ones, so they require a higher premium to compensate for the risk.
- Ignoring currency inflation mismatchUsing a dollar-based discount rate for rupee cash flows makes the company look artificially cheap, leading to costly mistakes.
Always adjust government yields for country default risk to find the real risk-free rate.
Indian stocks require a higher risk premium than mature US markets due to volatility.
Artificially low discount rates are a trap that makes expensive stocks look cheap.
We often pick a low discount rate not because it is correct, but because we want to justify buying a stock we have already fallen in love with.