There is renewed interest in infrastructure investing. They are an attractive substitute to the low-yielding bonds that have left many pension funds struggling, and politicians on both sides of the Atlantic are now talking about the need to invest in infrastructure.
Investing in real projects is challenging since we do not have the benefit of daily quotes, as in the case of traded securities. Furthermore, valuation techniques remain anchored in arcane ideas from times when simple algorithms were a necessity because computational power was expensive.
The standard valuation tool, the so-called discounted cash flow method, was introduced by Joel Dean in the 1950s. He extended a concept designed to value bonds to value projects by arguing that it was just a matter of estimating the net present value of the cash flows by discounting them with the appropriate interest rate: the riskier the project, the higher the discount rate. If the NPV was positive, the investment was worth pursuing. It seemed like a good idea, the concept stuck, and it became the backbone behind most investment decisions.
Unfortunately, the bond-project analogy is not as clean as it looks. Leaving aside the circularity of the discount rate recipe (how do we estimate the risk associated with a project if we do not know its value?), the most evident problem is that in the case of a bond all the discounted cash flows are positive; the only negative cash flow (the price paid for it) occurs initially, at the time the bond is bought.
In infrastructure projects, negative cash flows (expenses) occur frequently, and indeed, they are negative during the construction phase which can last several years. Thus, when we discount cash flows with a rate higher than the risk-free rate we are being overly pessimistic with the positive cash flows and overly optimistic with the negative cash flows. This situation introduces a systematic error in the valuation.
More precisely, the shortcomings of Dean’s method result from a theoretical flaw — attempting to capture with one number (the discount rate), two different effects: the time value of money and the uncertainty of the cash flows. However, it is in the practical arena where the DCF method encounters most difficulties: 70 years after its inception there is still no consensus on the “appropriate” discount rate.
In fact, the number of intellectual contortions related to coming up with the “appropriate” rate could fill an encyclopedia. Back in 1996, Eugene Fama (an economics Nobel winner) expressed serious doubts about the benefits of DCF, indicating that it was based more on faith than evidence. More recently (2011), John Cochrane, a University of Chicago professor, addressing the American Association of Finance, admitted how much is unknown about discount rates.
Moreover, large infrastructure projects can have long lifespans and for typical discount rate values, the conventional DCF implies that anything that happens after 20 years becomes irrelevant. Thus, the effect of DCF-led valuations is that they favour short-term gains at the expense of future generations — the method simply presents as unattractive any investment whose advantages might take a bit longer to emerge.
This has the obvious drawback of making raising capital for such projects more difficult, risking the postponement of essential investments. In essence, the DCF framework does not allow incorporating into the valuation the benefits (or disadvantages) that such projects can bring to future generations.
Some countries, aware of the short-term bias embedded in the DCF approach, have advocated the use of time-declining discount rates to evaluate long-term climate mitigating infrastructure projects. Kenneth Arrow, another economics Nobel laureate, last year co-authored a paper endorsing this idea. His suggestion, however looks a bit like rearranging the chairs in the Titanic.
The subprime crisis was a serious blow for economics. Most fundamental tenets of the discipline were left in tatters as the empirical evidence showed that they were less solid than previously believed. The conventional DCF method — since it did not play any role in the crisis — has so far gone unexamined. Yet, it remains one of the weakest elements of the economics canon. Valuation methods — not only for infrastructure projects but in general — should start by accepting that cash flows are uncertain and treat them accordingly. That is, relying on a branch of mathematics (probability and statistics) that knows how to deal with uncertainty. Making investment decisions based on ambiguous and ill-defined coefficients (discount factors) has no place in a rigorous analysis.
Finally, our wealth includes the potential earnings from the assets we own. Since the DCF method is the basic building block of our understanding of value, its widespread use begs the question of how rich (or poor) we really are. Do we know? We reckon that as long as we stick with the DCF method we never will.
Arturo Cifuentes is an adjunct professor at Colombia University, New York. David Espinoza is a senior principal at Geosyntec CAT, an advisory firm in Washington