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The risk-free rate in business valuation

Print Mail Rate-it

​​​​published on 5 December 2025 | reading time approx. 5 minutes


Every estimate of a company's value is based on a simple principle: today's value depends on future cash flows and the rate at which they are discounted. This rate – the cost of capital – always starts from a common component: the risk-free rate. Getting this starting point wrong means skewing the entire valuation model.

Theoretically, a rate is 'risk-free' only if it guarantees the repayment of capital and interest with certainty, without insolvency or reinvestment risk.

Practically, no security is completely safe: the risk-free rate is an approximation, a benchmark constructed to represent the minimum return an investor can obtain without exposing themselves to significant uncertainty.

Currency consistency

The first criterion to be met is consistency between the currency of the cash flows and that of the risk-free rate: if the flows are estimated in euros, the rate must be expressed in euros; if the valuation is in dollars, a dollar rate will be needed, and so on. 

This principle, which Damodaran calls the 'consistency rule', avoids a widespread and serious error: mixing returns from different currencies.

The risk-free rate should not reflect the risk of the country in which the company operates, but only the risk of the currency in which the cash flows are expressed.

For a European company, for example, it may be appropriate to use the yield on long-term German government bonds, which are considered the 'safest' in the eurozone.

The time horizon: thinking long term

A second key aspect is duration. In a valuation model, cash flows extend over many years – often indefinitely.

It therefore makes sense to use a risk-free rate that reflects a similar time horizon, i.e. the yield on long-term government bonds (10, 20 or 30 years).

Using a short-term rate, such as that of a three- or six-month security, creates a distortion: short-term rates are affected by cyclical fluctuations in the money market and do not reflect the yield structure that influences future cash flows.

The risk-free rate must instead represent a long-term perspective, consistent with the nature of equity investment.

When the government is not 'risk-free'

Many analysts mistakenly consider by default government bonds to be 'risk-free'. In reality, in several countries, the risk of sovereign default is not negligible.
A government bond with a medium or low rating incorporates a risk spread that negates the very definition of 'risk-free'.

In such cases, it is necessary to adjust the yield on the government bond by subtracting the estimated sovereign risk spread.

Another approach is to reconstruct a risk-free rate starting from a truly safe benchmark yield (such as US Treasuries) and adding the expected inflation differential of the local currency.

Real or nominal rate: consistency matters

Another crucial point is the consistency between cash flows and rates. If future cash flows are expressed in nominal terms, they must be discounted at a nominal risk-free rate.

If, on the other hand, the flows are real, i.e. already adjusted for inflation, a real rate is needed, which can be derived from inflation-indexed government bonds.

Confusing the two levels is a serious methodological error: discounting nominal flows with a real rate (or vice versa) significantly alters the values and distorts the final result.

'Abnormal' rates and the temptation to normalise

In recent years, government bond rates have often reached historically low levels, in some cases even negative.

This has raised doubts as to whether it is correct to use such 'anomalous' values as a basis for valuation, since a very low risk-free rate tends to increase company values.

According to Damodaran, automatically replacing the current rate with a historical average is a conceptual error.

The market rate represents the current reality, and if it is believed that rates will return to higher levels over time, this must become an explicit scenario, not a hidden adjustment. The key is always the transparency of assumptions, not the search for a 'fair rate' in the absolute sense.

Markets without reliable benchmarks

In some countries, especially emerging ones, there are no government bonds that can be considered 'risk-free'.

In these cases, it is possible to construct a theoretical rate by combining:
  • an international real reference rate (e.g. US Treasury inflation-indexed bonds);
  • plus the expected inflation rate of the local currency.

The result is an RF consistent with the reference currency, even in the absence of completely secure market instruments.

The most common errors

In summary, the most frequent errors in choosing the risk-free rate are:
  • using short-term rates for long-term valuations;
  • treating any government bond as risk-free;
  • using RF in a currency other than that of the estimated flows;
  • mixing real cash flows and nominal rates;
  • ignoring country risk in emerging markets;
  • introducing 'normalised' rates without explicitly justifying them.

Conc​​lusion

The risk-free rate is not a number to be taken for granted, but a conscious choice that defines the entire valuation architecture.
​
It is the starting point from which all forms of risk and return are measured. Damodaran's lesson is simple but profound: rather than seeking absolute precision, what matters is the internal consistency of the model.
​

A risk-free rate chosen methodically, in line with the currency, duration and nature of the cash flows, makes the valuation not only more robust from a technical point of view, but also more credible in the eyes of the reader.

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Stefano Damagino

Certified Tax Consultant, statutory auditor (Italy)

Associate Partner

+39 02 6328 841

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