The backbone of valuation for these companies is discounted cash flow analysis.
A sensitivity analysis can be performed to determine the foreign exchange impacts
To many, valuing firms from an emerging market seems too difficult to undertake.
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The world has become a smaller place than ever before. With advancements in science and technology, economies from all corners of the globe have become interdependent and firms that do business in emerging and frontier economies are accessible to both consumers and investors from developed nations. With the ever-increasing growth of emerging economies, such as the BRIC nations, investors are looking for more and more ways to diversify their portfolios to include securities from these markets. A major issue that many fund managers and individual investors face, however, is how to properly value companies that do the majority of their business in emerging market economies. In this article we will look at common approaches prescribed by the CFA Institute, along with the factors that must be accounted for when attempting to place a value estimate on emerging market companies.
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DCF in Emerging Markets
While the idea of placing a value on an emerging market firm may seem difficult, it really is not much more different than valuing a company from a more familiar developed economy; the backbone of valuation is still discounted cash flow analysis.Although the concept is the same, there are still a few factors specific to emerging markets that must be dealt with. For example, the effect of exchange rates, interest rates and inflation estimates are obvious concerns when analyzing emerging market firms. Exchange rates are regarded as relatively unimportant by most analysts, since although the local currencies of emerging market countries can vary wildly in relation to the dollar (or other more established currencies), they tend to stay close in relation to the nation’s purchasing power parity (PPP). So in this case, changes in exchange rate will have little effect on the future domestic business estimates for an emerging market firm. Nonetheless, a sensitivity analysis can be performed to determine the foreign exchange impacts due to local currency fluctuations. (Calculate whether the market is paying too much for a particular stock. Check out DCF Valuation: The Stock Market Sanity Check .)
Inflation on the other hand plays a larger role on valuation, especially for firms operating in a potentially high inflation setting. In order to neutralize the effects of inflation on the DCF estimate for an emerging market firm, it is necessary to estimate future cash flows in both nominal (ignoring inflation) and real (adjusting for inflation) terms. By estimating future cash flows in both real and nominal terms and discounting them at appropriate rates (once again, adjusting for inflation when necessary) we should be able to derive firm values that are reasonably close if inflation has been properly accounted for.Making the appropriate adjustments to the numerator and denominator of the DCF equations removes the impact of inflations. (Inflation is often a consequence of economic recovery. Here’s how you can protect your financial portfolio. Refer to Fight Back Against Inflation .)
Obtaining the DCF Inputs
A major hurdle in deriving free cash flow estimates in emerging markets is estimating the cost of capital for a firm. Both a firm’s cost of equity and cost of debt, along with the actual capital structure itself have inputs that are a challenge to estimate in emerging markets. The biggest difficulty in estimating the cost of equity will inherently be deciding on the risk-free rate, since emerging market government bonds cannot be considered riskless investments. Therefore, the CFA Institute suggest adding the inflation rate differential between the local economy and a developed nation and using that as a spread on top of that same developed nation’s long-term bond yield.
In the case of estimating the cost of debt, using comparable spreads from developed nations on similar debt issues to that of the firm in question, and adding that on to the derived risk-free from above will give an acceptable pre-tax cost of debt, a necessary input for calculating the company’s cost of debt . This methodology factors in the assumption that the risk free rate of an emerging market is not actually free of risk. Finally, to choose an appropriate capital structure, it is best to use an industry average. If no local industry average is available, using a regional or global average will work as well.
Other Considerations
Another key to arriving at a usable value via the DCF method is including a country risk premium to the firm’s weighted average cost of capital (WACC). The reason for this is to be sure we are using an appropriate discount rate when using nominal figures in discounting the firm’s future cash flows. The key here is to choose a country risk premium that fits with the overall picture of the firm and the economy. There is hard and fast rule to choosing a country risk premium, however quite often individuals (both amateurs and professionals alike) will overestimate the premium. A good method suggested by the CFA Institute is to look at the premium in the context of the capital asset pricing model (CAPM), making sure that the historical returns of a company’s stock is taken into account.
The last piece of the valuation puzzle, much like with forms from developed economies, is to compare the firm to its industry peers on a multiple basis. Evaluating the company against similar emerging market firms on multiples, namely the enterprise multiple, will help give a clearer picture of how the firm stacks up relative to others within its industry, especially if said peers compete within the same emerging economy.
Conclusion
To many, valuing firms from an emerging market seems much too difficult to undertake. We hope that this article has helped you see that the basic valuation approaches for emerging market companies is very similar to the valuation of more familiar developed economy firms, just with a few factors to adjust for in your estimates. As nations like
China
,
India
and others continue to grow economically and leave their footprint on the global economy, valuing companies from such nations will be an important part of building a truly global portfolio. (The rewards associated with this fixed-income asset are significant, but so are the risks. Check out An Introduction To Emerging Market Bonds .)
by Investopedia Staff
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.
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