The world is more connected than ever before. With advancements in science and technology, economies from all corners of the globe have become interdependent. This interdependence means that 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 Brazil, Russia, India, and China, known as the BRIC nations, investors are looking for ways to diversify their portfolios to include securities from these markets.
- Investors are building their portfolios by investing in emerging markets.
- Fund managers and individual investors need reliable ways to value emerging market companies accurately.
- The same approaches that are used for developed economies can be applied to emerging economies with certain adjustments.
Understanding Emerging Markets
A major challenge that many fund managers and individual investors face is how to properly value companies that do the majority of their business in emerging market economies.
In this article, we 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.
Discounted Cash Flow Analysis
While the idea of placing a value on an emerging market firm may seem difficult, the process is similar to the valuation of a company from a developed economy. The basis of valuation is discounted cash flow analysis (DCF). The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money.
Although the concept is the same, there are factors to consider specific to emerging markets. For example, the effects of exchange rates, interest rates, and inflation estimates are concerns when analyzing emerging market firms because these markets are more volatile.
Exchange rates are considered relatively unimportant by most analysts. Although the local currencies of emerging market countries can vary wildly in relation to the dollar (or other more established currencies), they tend to follow the nation's purchasing power parity (PPP). Therefore, changes in the exchange rate will have little effect on future domestic business estimates for an emerging market firm. Nonetheless, a sensitivity analysis can indicate the foreign exchange impacts of local currency fluctuations.
On the other hand, inflation plays a larger role in valuation, particularly for firms operating in a potentially high inflation setting. Future cash flows are estimated on both nominal (ignoring inflation) and real (adjusting for inflation) terms to neutralize the effects of inflation on the DCF estimate for an emerging market firm. By estimating future cash flows in both real and nominal terms and discounting them at appropriate rates (once again, adjusting for inflation when necessary), the derived firm values will be 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 inflation.
Adjustments for Calculating DCF in Emerging Markets
Cost of Capital
A major hurdle in deriving free cash flow estimates in emerging markets is estimating a firm's cost of capital. Both a firm's cost of equity and cost of debt, along with the actual capital structure itself, have inputs that are challenging to estimate in emerging markets. The greatest 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 suggests adding the inflation rate differential between the local economy and a developed nation and using that as a spread on top of that developed nation's long-term bond yield.
Cost of Debt
The cost of debt can be calculated using comparable spreads from developed nations on similar debt issues to those affecting the firm in question. Adding these to the derived risk-free rate 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, an industry average should be used for capital structure. If no local industry average is available, a regional or global average is an alternative.
Weighted Average Cost of Capital
Including a country risk premium to the firm's weighted average cost of capital (WACC) improves the DCF. This ensures that an appropriate discount rate is applied when using nominal figures to discount the firm's future cash flows. A country risk premium should be selected that fits with the overall picture of the firm and the economy.
There is a hard and fast rule when choosing a country risk premium. However, quite often individuals (both amateurs and professionals) will overestimate the premium. A method recommended 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 are taken into account.
A thorough evaluation, much like with companies from developed economies, should include a comparison of the firm with industry peers. Evaluating the company against similar emerging market firms on multiples, namely, the enterprise multiple, will provide a clearer picture of how the business stacks up relative to others within its industry. This is particularly relevant if the peers compete within the same emerging economy.
The Bottom Line
Valuing firms from an emerging market may seem like a difficult undertaking. However, the basic valuation approaches used for developing economy companies can be applied to emerging market companies with some adjustments.
As nations like China, India, Brazil, 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.