Value a business in emerging markets, is giving rise to some special accounting perks, here are the explanations…
The emerging economies in Asia and South America continue experience strong growth over the coming decades. Over the long term, many analysts see China and India moving into the ranks of the world’s largest economies. This sometimes spectacular economic development will produce many situations requiring sound analysis and valuation. In the rising number of privatizations, joint ventures, mergers, and acquisitions, local financial parties such as banks and capital markets will display growing sophistication. Institutional investors will also continue to diversify their portfolios, adding international holdings in emerging-market stocks.
Here the focus is on the specific issues that arise in financial analysis and valuation of businesses in emerging markets. Valuation is typically more difficult in these environments because of various risks and possible obstacles to businesses. These include macroeconomic uncertainty, illiquid capital markets, controls on the flow of capital into and out of the country, less rigorous standards of accounting and disclosure, and high levels of political risk. It is impossible to generalize about these risks, as they differ by country and may affect businesses in different ways. Academics, investment bankers, and industry practitioners have yet to agree on how to address them. Methods vary considerably, and practitioners often make arbitrary adjustments based on intuition and limited empirical evidence.
Since emerging-market valuations are so complex and there is no agreed upon method, a triangulation approach is used—comparing estimates of value derived from three different methods.
- Discounted cash flows (DCFs) with probability-weighted scenarios that model the risks the business faces.
- Compare the value obtained from this approach with the results of two secondary approaches:
- a DCF valuation with a country risk premium built into the cost of capital, and
- a valuation based on comparable trading and transaction multiples.
This approach is illustrated with the valuation of ConsuCo, a Brazilian retail company focusing on both food and durable consumer goods.
In the case of ConsuCo, there are no major accounting differences to adjust for. Brazilian Generally Accepted Accounting Principles (GAAP) changed at the end of 2006 and have become very similar to International Financial Reporting Standards (IFRS) and US GAAP regarding, for instance, accounting for leases, derivatives, and stock-based compensation. To illustrate, before this change, ConsuCo treated all leases as off-balance-sheet operating leases. It now applies the same standards as under US GAAP for classifying leases as either operating or financial, including additional disclosure requirements. Although most leases still remain operating, this doesn’t affect the assessment, because a standard capital adjustment for operating leases is made. One area where a difference remains is goodwill, which can be amortized under Brazilian GAAP. In addition, any goodwill is measured relative to the book value of the relevant assets and liabilities, whereas U.S. GAAP typically uses their fair value. Again, the assessment for valuation is not affected, because any goodwill amortization is added back on a cumulative basis to calculate invested capital.
Having found no major accounting differences to manage, ConsuCo’s historical financial statements are analysed, rearranging the balance sheet and the income statement to get the statements for net operating profit less adjusted taxes (NOPLAT), invested capital, and free cash flow. Then some key financial ratios are estimated on an approximate real-terms basis. Although annual inflation in Brazil has been moderate since 1997 at an average level of 7 percent, ratios such as operating margin and capital turnover are likely to be biased by inflation when directly calculated from the financial statements. To offset this bias, trends in cash operating margins are analysed—that is, earnings before interest, taxes, depreciation, and amortization (EBITDA) over sales. In addition, sales are estimated in real terms per store and per square meter of store space over time, to understand the development of real-terms capital turnover. The results of this exercise are as follows:
Between 2004 and 2008, ConsuCo’s sales growth in real terms was highly volatile, with a compound annual growth rate of 3.4 percent, similar to the growth in the number of stores and very close to real GDP growth. This was very much driven by strong growth in 2008, which was mostly due to improved average store performance. Still, average growth since 2003 is relatively low compared with the preceding five years: the average real growth over the past 10 years was about 6 percent per year. The average level of sales per store in real terms has been quite stable, but this does not reflect the increasing store size. With average sales per square meter decreasing and store size increasing, profit margins and ROIC performance have deteriorated: EBITDA margin has decreased to around 7 percent since 2005, and ROIC is now about 6 percent.
Performance in 2008 suggests that recently launched initiatives to improve efficiency and productivity are starting to pay off, but a key question is how much further potential remains to be materialized and consequently what levels of long-term growth and return on invested capital (ROIC) are sustainable. Before looking at the financial forecasts for ConsuCo in more detail, some of the more technical points about assumptions that are fundamental to creating a financial forecast are reviewed.
Determine a consistent set of assumptions
Every forecast of a company’s financial performance is based on a set of economic and monetary assumptions about, for instance, exchange rates, inflation rates, and interest rates. In emerging markets, however, these parameters can fluctuate wildly from year to year. It is therefore crucial to make sure not only that each of these parameters is reflected in the financial forecasts of the company, but also that these assumptions are internally consistent.
Creating one integrated set of economic and monetary assumptions that include, among others, real GDP growth; price inflation (consumer prices, wages, etc.); interest rates; exchange rates; and whatever other parameters are deemed relevant (e.g., oil prices) is paramount. The purpose is not so much to create the right economic forecasts—these will always be uncertain—but rather to create one or more sets of consistent assumptions to apply to the valuation.
An important parameter is the exchange rate. Like many international companies, the cash flows of emerging-market companies can be denominated in several currencies. Consider a national oil company that exports oil. Its revenues are determined by the dollar price of oil, while many of its costs, especially labor and domestic purchases, are determined by the domestic currency. If foreign-exchange rates perfectly reflected inflation differentials (so that purchasing power parity held), the company’s operating margins and cash flows in real terms would be unaffected. In that case, changes in exchange rates would be irrelevant for valuation purposes.
When estimating the impact of exchange rate movements on cash flow forecasts, keep in mind that the evidence shows that purchasing power parity (PPP) does hold over the long run, even between emerging and developed economies. In other words, exchange rates ultimately do adjust for differences in inflation between countries. For example, if you held $100 million of Brazilian currency in 1964, by 2008 it would have been practically worthless in U.S. dollars. Yet adjusting for purchasing power, the value of the currency has fluctuated around the $100 million mark during the 44-year period. Suppose that, instead of holding $100 million of Brazilian currency, you held $100 million of assets in Brazil whose value increased with inflation. In about half the years, their value would have been within 15 percent of the original investment, but in other years, it might have deviated much more, either positively or negatively. For example, at the end of 2008, the assets would have been worth approximately $150 million. The estimated real (inflation-adjusted) exchange rate for the Brazilian currency, which explains this effect.
– Brazilian PPP-Adjusted Dollar Exchange Rate
R$ per US$ index, 1964 – 100
Source: MCM Consultants, IMF International Financial Statistics, Datastream.
In the case of ConsuCo, the underlying exchange rate exposure is limited, as the company has very few cash flows denominated in foreign currency. No adjustments for a change in the exchange rate has been made, even though the real (Brazilian currency) is at 70 percent of PPP. It might, however, be relevant to consider the indirect impact that a convergence of the real and nominal exchange rates could have on the growth and potential profitability of the Brazilian consumer goods sector and ConsuCo.
The economic and monetary assumptions that are used for ConsuCo’s valuation, focusing only on real GDP growth and inflation, are as follows:
Economic and Monetary Assumptions (in percentage)
Source: IMF World Economic Outlook.
Real GDP growth is expected to be between 3 and 4 percent a year, whereas annual inflation is expected to stay just above 4 percent.
Forecasting cash flow data
Historical analysis showed a turnaround in ConsuCo’s performance during 2008. Based on the historical analysis and information from analyst reports up to September 2009, operating and financial forecasts were made as summarized in real and nominal terms below.
ConsuCo: Summary Financial Projections, Base Case
Capital expenditure is inflation adjusted, Invested capital is excluding goodwill
- No major economic crisis will materialize in Brazil after 2010.
- The turnaround of ConsuCo is genuine and sustainable. During the past few years, management of the company has changed, and current management has a strong track record in delivering the turnaround. The company has put a lot of effort into improving same-store sales growth in food, which first showed in 2008’s results. In the non-food segment (items such as furniture and electronics), ConsuCo is also well positioned by having various different formats and channels. These categories currently have a low penetration in Brazil and are expected to show double-digit growth over the years to come. Finally, through some portfolio changes, the company entered new regions in Brazil where it can roll out some of its existing formats. Therefore it is assumed that the company can deliver about 10 percent real sales growth in the short term, gradually declining to the longer-term historical average of 6 percent. In the very long term, the expected Brazilian economic growth rate is thought to be in line with average historical real GDP growth rates in the United States.
- Only limited improvement in operating margins is forecasted. Despite continuing efficiency gains, we expect increasing competition for market share to put downward pressure on the margins at the same time and therefore are conservative about seeing further margin improvement in the continuing value period.
- Capacity requirements and expected capital expenditures are derived from real growth forecasts in combination with assumed increases in sales productivity. Sales productivity is expected to improve again over the next few years, with sales per square meter of store space returning to a level similar to that of about five years ago. However, to realize sales productivity, ConsuCo will also have to invest in substantial reformatting of stores, resulting in an increase in total net property, plant, and equipment (net PP&E) per square meter. As a result, invested capital as a percent of sales will initially drop in real terms but slowly increase again in the longer term.
- Although ROIC in real terms will increase until 2011 as a result of improved sales productivity,we expect it to come down after that to just under 6 percent in the continuing-value period. In contrast, the ROIC in nominal terms increases from 8 percent to 9 percent because of inflation’s impact on capital turnover.
Strong growth in the first four years, combined with the reformatting and upgrading of stores, means that free cash flow is negative in those years because of the significant investments that this requires. If growth in capacity and revenues in 2010 were a few percentage points lower, the free cash flow would become positive.
Inclusion of emerging-market risks in the valuation model
The major distinction between valuing companies in developed markets and in emerging markets is the increased level of risk in the latter. There is not only a need to account for risks related to the company’s strategy, market position, and industry dynamics, as in a developed market, but there is also a need to deal with the risks caused by greater volatility in the local capital markets and macroeconomic and political environments.
There is no consensus on how to reflect this higher level of risk in a premium to the discount rate. The alternative is to model risks explicitly in the cash flow projections in what is called the scenario DCF modelling. Both methodologies, if correctly and consistently applied, lead to the same result. This shows in the following example of an investment in two identical production plants, one in Europe and the other in an emerging economy. However, the scenario DCF modelling is analytically more robust and does a better job of showing the impact of emerging-market risks on value.
Scenario DCF modelling
The scenario DCF modelling simulates alternative trajects for future cash flows. At a minimum, use two scenarios: The first should assume that cash flow develops according to conditions reflecting business as usual (i.e., without major economic distress). The second should reflect cash flows assuming that one or more emerging-market risks materialize.
Scenario DCF versus Country Risk Premium DCF
Net present value for identical facilities in
….. a European market ———————————————————————— …. OR AN EMERGING MARKET
1. Assuming perpetuity cash flow growth of 3% Value a business in emerging markets
2. Assuming perpetuity cash flow growth of 3% and recovery under distress of 45% of cash flows ‘as usual’.
In the example, the cash flows for the European plant grow steadily at 3 percent per year into perpetuity. For the plant in the emerging market, the cash flow growth is the same under a business-as-usual scenario, but there is a 25 percent probability of economic distress resulting in a cash flow that is 55 percent lower into perpetuity. The emerging-market risk is taken into account, not in the cost of capital but in the lower expected value of future cash flows from weighting both scenarios by the assumed probabilities. The resulting value of the emerging-market plant (€1,917) is clearly below the value of its European sister plant (€2,222), using a weighted average cost of capital (WACC) of 7.5 percent.
For simplicity it is also assumed that if adverse economic conditions develop in the emerging market, they will do so in the first year of the plant’s operation. In reality, of course, the investment will face a probability of domestic economic distress in each year of its lifetime. Modelling risk over time would require more complex calculations yet would not change the basic results. It is also assumed that the emerging-market business would face significantly lower cash flows in a local crisis but not wind up entirely worthless.
Inclusion of country risk premium
The second approach is to add a country risk premium to the cost of capital for comparable investments in developed markets. Then apply the resulting discount rate to the cash flow projections in a business-as-usual scenario. The key drawback is that there is no objective way to establish the country risk premium. For the two-plant example, in hindsight it is derived what the premium should be to obtain the same result as under the scenario DCF approach. To arrive at a value of €1,917 for the emerging-market plant, the discount rate for the business-as-usual projections would have to be 8.2 percent, which translates to a country risk premium of 0.7 percent.
On occasion, practitioners make the mistake of adding the country risk premium to the cost of capital to discount the expected value of future cash flows, rather than to the promised cash flows of a business-as-usual scenario. The resulting value is too low because this approach accounts twice for the probability of a crisis.
Some surveys show that managers generally adjust for emerging-market risks by adding a risk premium to the discount rate. Nonetheless, it is preferred to use the scenario DCF valuation as the primary approach and using the country risk premium and multiples approaches for triangulation. Scenario DCF valuation provides a more solid analytical foundation and a more robust understanding of the value than incorporating country risks in the discount rate.
One reason is that most country risks, including expropriation, devaluation, and war, are largely diversifiable (though not entirely, as the economic crises in 1998 and 2008 demonstrated). Consider the international consumer goods player illustrated below.
Returns on Diverse Emerging-Market Portfolio
Source: Company information Value a business in emerging markets
Its returns on invested capital were highly volatile for individual emerging markets, but taken together, these markets were hardly more volatile than developed markets; the corporate portfolio diversified away most of the risks. Finance theory clearly indicates that the cost of capital should not reflect risk that can be diversified. This does not mean that diversifiable risk is irrelevant for a valuation: the possibility of adverse future events will affect the level of expected cash flows, as in the example in Scenario DCF versus Country Risk Premium DCF (above). But once this has been incorporated into the forecast for cash flows, there is no need for an additional markup of the cost of capital if the risk is diversifiable. IFRS 13 Value a business in emerging markets
Another argument against a country risk premium is that many country risks apply unequally to companies in a given country. For example, banks are more likely to be affected than retailers. Some companies (raw materials exporters) might benefit from a currency devaluation, while others (raw-materials importers) will be damaged. For the consumer goods company in the graphics on ‘Returns on Diverse Emerging-Market Portfolio’, economic crises had only a short-term impact on sales and profit as measured in the parent’s domestic, stable currency. In most cases, after a year or two, sales and profits roughly regained their original growth trajectories. Applying the same risk premium to all companies in an emerging market could overstate the risk for some businesses and understate it for others. IFRS 13 Value a business in emerging markets
Furthermore, there is no systematic method to calculate a country risk premium. In the example, this premium could be re-engineered because the true value of the plant was already known from the scenario approach. In practice, the country risk premium is sometimes set at the spread of the local government debt rate denominated in U.S. dollars and a U.S. government bond of similar maturity. However, that is reasonable only if the returns on local government debt are highly correlated with returns on corporate investments. IFRS 13 Value a business in emerging markets
From an operational viewpoint, when managers have to discuss emerging market risks and their effect on cash flows in scenarios, they gain more insights than they would get from a so-called black-box addition to the discount rate. By identifying specific factors with a large impact on value, managers can plan to mitigate these risks. Last but not least, managers easily underestimate the impact that even a small country risk premium in the discount rate may have on valuations: in the example shown in graphics on ‘Returns on Diverse Emerging-Market Portfolio’, setting a country risk premium of 3 percent would be equivalent to assuming a 70 percent probability of economic distress.
Developing cash flow scenarios and probabilities IFRS 13 Value a business in emerging markets
To use the scenario DCF approach, construct at least two scenarios.
The base case, or business-as-usual scenario, describes how the business will perform if no major crises occur. The downside scenario describes the financial results if a major crisis does occur.
There is already a set of macroeconomic and monetary assumptions for the ConsuCo base case. Now a set of assumptions need to be developed for the downside scenario. The major macroeconomic variables to forecast are GDP growth, inflation rates, foreign-exchange rates, and interest rates. These items must be linked in a way that reflects economic realities and should be included in the basic set of monetary assumptions underlying the valuation. For instance, when constructing a downside scenario with high inflation, make sure that the same inflation rates underlie the financial projections and cost of capital estimates for the company. Foreign-exchange rates should also reflect this pattern of inflation in the long run, because of purchasing power parity.
Given the assumptions for macroeconomic performance, the industry scenarios are largely construed in the same way as for valuations in developed markets. The major difference is the greater uncertainty involved in modelling outcomes under severe crises for which there may be no precedent.
To construct ConsuCo’s downside scenario, an analysis is made of its performance under more adverse economic conditions in the past. Brazil has experienced several severe economic and monetary downturns, including an inflation rate that topped 2,000 percent in 1993. Judging by its key financial indicators, such as EBITDA to sales and real-terms sales growth, the impact on ConsuCo’s business performance was significant. ConsuCo’s cash operating margin was negative for four years, at around –10 to –5 percent, before recovering to its normal levels. In the same period, sales in real terms declined by 10 to 15 percent per year but grew sharply after the crisis. For the downside scenario projections, similar negative cash margins and a real-terms decline in sales are assumed for up to five years, followed by a gradual return to the long-term margins and growth assumed under the business-as-usual scenario. The graphic and tables below compares the nominal and real returns on invested capital under both scenarios.
ConsuCo: ROIC and Financials, Base Case vs. Downside Scenario IFRS 13 Value a business in emerging markets
In the downside scenario, the returns plummet and then increase as the recovery starts. After 2014, the nominal returns overtake those in the base case, as extreme inflation pushes up capital turnover. Of course, the nominal returns are artificially high, as a comparison with the real returns shows. The DCF value in the downside scenario will turn out to be just under half of the base case value. Free cash flow would be several billion R$ negative, which would put a strong financing burden on ConsuCo: under such a scenario, ConsuCo would probably have to revise its growth strategy.
While estimating probabilities of economic distress for the cash flow scenarios is ultimately a matter of management judgment, there are indicators to suggest what probabilities would be reasonable. Historical data on previous crises can give some indication of the frequency and severity of country risk and the time required for recovery. Analysing the changes in GDP of 20 emerging economies over the past 20 years, we found they had experienced economic distress about once in every five years (a real-terms GDP decline of more than 5 percent). This would suggest a 20 percent probability for a downside scenario.
Another source of information for estimating probabilities is prospective data from current government bond prices. Recent academic research suggests that government default probabilities five years into the future in emerging markets such as Argentina were around 30 percent in non-distress years. The probability of the downside scenario materializing for ConsuCo is estimated at around 30 percent.
Discounting in emerging markets
Calculating the cost of capital in any country can be challenging, but for emerging markets, the challenge is an order of magnitude higher. Here are the fundamental assumptions provided, including background on the important issues, and a practical way to estimate the components of the cost of capital.
The analysis adopts the perspective of a global investor—either a multinational company or an international investor with a diversified portfolio. Of course, some emerging markets are not yet well integrated with the global market, and local investors may face barriers to investing outside their home market. As a result, local investors cannot always hold well-diversified portfolios, and their cost of capital may be considerably different from that of a global investor. Unfortunately, there is no established framework for estimating the capital cost for local investors. Furthermore, as long as international investors have access to local investment opportunities, local prices will be based on an international cost of capital. Finally, according to empirical research, emerging markets have become increasingly integrated into global capital markets. This trend is expected to continue and most countries will gradually reduce foreign investment restrictions for local investors in the long run.
Another assumption is that most country risks are diversifiable from the perspective of the global investor. No additional risk premiums in the cost of capital for the risks encountered in emerging markets when discounting expected cash flows is needed. Of course, it is possible, if and when required in the business case, to discount the promised cash flow from the business-as-usual scenario only and add a country risk premium.
Given these assumptions, the cost of capital in emerging markets should generally be close to a global cost of capital adjusted for local inflation and capital structure. It is also useful to keep some general guidelines in mind:
- Use the capital asset pricing model (CAPM) to estimate the cost of equity in emerging markets. The CAPM may be a less robust model for the less integrated emerging markets, but there is no better alternative model today. Furthermore, we believe it will become a better predictor of equity returns worldwide as markets continue to become more integrated.
- There is no one right answer, so be pragmatic. In emerging markets, there are often significant information and data gaps (e.g., for estimating betas or the risk-free rate in local currency). Be flexible as you assemble the available information piece by piece to build the cost of capital, and triangulate your results with country risk premium approaches and multiples.
- Be sure monetary assumptions are consistent. Ground your model in a common set of monetary assumptions to ensure that the cash flow forecasts and discount rate are consistent. If you are using local nominal cash flows, the cost of capital must reflect the local inflation rate embedded in the cash flow projections. For real-terms cash flows, subtract inflation from the nominal cost of capital.
- Allow for changes in cost of capital. The cost of capital in an emerging market valuation may change, based on evolving inflation expectations, changes in a company’s capital structure and cost of debt, or foreseeable reforms in the tax system. For example, in Argentina during the economic and monetary crisis of 2002, the short-term inflation rate was 30 percent. This could not have been a reasonable rate for a long-term cost of capital estimate, because such a crisis could not be expected to last forever 3. In such cases, estimate the cost of capital on a year-by-year basis, following the underlying set of basic monetary assumptions.
- Don’t mix approaches. Use the cost of capital to discount the cash flows in a probability-weighted scenario approach. Do not add any risk premium, because then double-counting risk occurs. When discounting only future cash flows in a business-as-usual scenario, add a risk premium to the discount rate.
Estimating the Cost of Equity
Risk-free rate In emerging markets, the risk-free rate is harder to estimate from government bonds than in developed markets. Three main problems arise:
- Most of the government debt in emerging markets is not, in fact, risk free: the ratings on much of this debt are often well below investment grade,
- It is difficult to find long-term government bonds that are actively traded with sufficient liquidity, and
- The long-term debt that is traded is often in U.S. dollars, a European currency, or the Japanese yen, so it is not appropriate for discounting local nominal cash flows.
But to keep it simple use a straightforward approach. Start with a risk-free rate based on the 10-year U.S. government bond yield, as in developed markets. Add to this the projected difference over time between U.S. and local inflation, to arrive at a nominal risk-free rate in local currency4. Sometimes this inflation differential is obtained from the spread between local government bond yields denominated in local currency and those denominated in U.S. dollars.
Beta Sometimes practitioners calculate beta relative to the local market index. This is not only inconsistent from the perspective of a global investor, but also potentially distorted by the fact that the index in an emerging market will rarely be representative of a diversified economy. Instead, estimate industry betas relative to a well-diversified or global market index.
To estimate the beta for ConsuCo, examine its own beta and those of peer companies, just as would be done in the case of a company from a developed market. The asset betas for retail companies in the United States and Europe is estimated just as well as for several larger retail companies in Latin America. Look at long-term historical average betas to avoid distortion due to the recent economic crisis. The results are presented below.
–ConsuCo: Estimating Beta
1 Based on beta development since January 2005, with beta calculated from 5 years of monthly data in dollars.
The average beta of U.S. and European retail companies is around 0.7. For the Latin American peers, betas appear to be much higher, but large-cap retailers more similar in size to ConsuCo have betas in the range of 0.7 to 1.0. Given that ConsuCo’s own beta estimate at 0.81 is also in that range, it seems appropriate to use a beta that is above the U.S. and European peer group. However, the Latin American peer group of large retailers is very small, because it is generally harder to find a sizable sample of publicly traded local peer companies in emerging markets. In this case, it is suggested to triangulate the results as follows. First, identify the broader industry or sector index in the emerging market or region where the company is active. Second, examine whether there is any consistent markup over several years in the beta estimate for that index versus a U.S.-European index for the same sector. Third, add the estimated markup, if any, to the beta estimate for a sample of U.S.-European peer companies.
The beta of the Brazilian market as a whole is examined, as well as the broader consumer goods and services sector in Brazil (which includes more than retail companies).
Equity Market and Consumer Sector Betas
1 Beta calculated from 5 years of monthly data in dollars.
As shown above, the Brazilian betas are in both cases well above the U.S. and European levels. The beta for the Brazilian market as a whole has been approximately 60 to 70 percent above the United States and Europe over the past decade. However, the industry composition of the Brazilian stock market is quite different from that of the United States and Europe, so this comparison does not reveal much. More meaningful is the comparison of the Brazilian consumer goods and services sector beta with the corresponding U.S. and European sectors. The same exhibit shows that in recent history, the beta for the Brazilian consumer goods and services sector was at a fairly consistent premium of around 25 percent relative to that of the United States and Europe.
Bringing all the evidence together, we estimate ConsuCo’s beta at 0.8, which is in fact equal to its own beta estimate. It corresponds to a 25 percent premium 5 to the average asset beta for the U.S. and European retail peers and is in line with ConsuCo’s larger Latin American peers. Value a business in emerging markets
Market risk premium Excess returns of local equity markets over local bond returns are not a good proxy for the market risk premium. This holds even more so for emerging markets, given the lack of diversification in the local equity market. Furthermore, the quality and length of available data on equity and bond market returns usually make such data unsuitable for long-term estimates. To use a market risk premium that is consistent with the perspective of a global investor, use a global estimate of 4.5 to 5.5 percent.
ConsuCo: Cost of Equity Estimate IFRS 13 Value a business in emerging markets
1 Brazilian risk-free rate estimated as: [(1 + U.S. risk-free rate)(1 + U.S. inflation)]/(1 + Brazilian inflation) – 1. Value a business in emerging markets
Source: IMF World Economic Outlook, Bloomberg
Above is a summary of the nominal cost of equity calculation for ConsuCo in the base case scenario. In this scenario, a fairly stable inflation rate for the Brazilian economy is assumed. Due to the global slowdown, near-term inflation is expected to decrease somewhat and come back to about 4.5 percent in 2014, beyond which it is assumed to be constant. For the downside scenario (not shown in the exhibit), inflation projections follow a different trajectory, and the cost of capital for this scenario is adjusted accordingly. (The resulting cost of equity is shown later, in the WACC estimate table) Value a business in emerging markets
Estimating the After-Tax Cost of Debt IFRS 13 Value a business in emerging markets
In most emerging economies, there are no liquid markets for corporate bonds, so little or no market information is available to estimate the cost of debt. However, from an international investor’s perspective, the cost of debt in local currency should simply equal the sum of the dollar (or euro) risk-free rate, the systematic part of the credit spread, and the inflation differential between local currency and dollars (or euros). Most of the country risk can be diversified away in a global bond portfolio. Therefore, the systematic part of the default risk is probably no larger than that of companies in international markets, and the cost of debt should not include a separate country risk premium.
ConsuCo: Cost of Debt Estimate IFRS 13 Value a business in emerging markets
This explains why the funding costs of multinationals with extensive emerging-market portfolios—companies including Coca-Cola and Colgate-Palmolive—have a cost of debt that is no higher than that of their mainly U.S.-focused competitors.
Returning to the ConsuCo example, we calculated the cost of debt in R$. ConsuCo does not have its own credit rating, but based on comparison with peers, we estimate that ConsuCo would probably have a rating of BBB to A. ConsuCo’s cost of debt can be estimated as the sum of the risk-free rate in R$ plus the systematic credit spread for U.S. and European corporate bonds rated BBB to A versus the government bond yield, as shown in ‘ConsuCo: Cost of Debt Estimate’. Of course, the inflation assumptions underlying the estimates for cost of debt should be consistent with those for the base case and the downside scenario.
The marginal tax rate in emerging markets can be very different from the effective tax rate, which often includes investment tax credits, export tax credits, taxes, equity or dividend credits, and operating loss credits. Few of these arrangements provide a tax shield on interest expense, and only those few should be incorporated in the WACC estimate. Other taxes or credits should be modeled directly in the cash flows. For ConsuCo, the Brazilian corporate income tax rate of 25 percent plus social contribution tax of 9 percent is used.
Estimating WACC IFRS 13 Value a business in emerging markets
Having estimated the cost of equity and after-tax cost of debt, we need debt and equity weights to derive an estimate of the weighted average cost of capital. In emerging markets, many companies have unusual capital structures compared with their international peers. One reason is, of course, the country risk: the possibility of macroeconomic distress makes companies more conservative in setting their leverage. Another reason could be anomalies in the local debt or equity markets. In the long run, when the anomalies are corrected, the companies should expect to develop a capital structure similar to that of their global competitors. The model can potentially forecast explicitly how the company evolves to a capital structure that is more similar to global standards.
For the ConsuCo case, the capital structure is set close to the peer group average at a ratio of debt to enterprise value of 0.3, which is also in line with its long-term historical levels. Exhibit 33.12 summarizes the WACC estimates for the base case and the downside scenario in nominal terms. Note how the extreme inflation assumption underlying the downside scenario leads to a radically higher cost of capital in the crisis years until 2014, when it starts to fall. Value a business in emerging markets
Estimating the Country Risk Premium IFRS 13 Value a business in emerging markets
If you are discounting business-as-usual cash flows instead of expected cash flows, you should add a country risk premium to the WACC, as we saw earlier in this chapter in the section on incorporating emerging-market risks in the valuation. There is no agreed-upon approach to estimating this premium, but we have some advice.
Do not simply use the sovereign risk premium The long-term sovereign risk premium equals the difference between a long-term (e.g., 10-year) U.S. government bond yield and a dollar-denominated local bond’s stripped yield 6 with the same maturity. This difference will reasonably approximate the country risk premium only if the cash flows of the corporation being valued move closely in line with the payments on government bonds. This is not necessarily the case. In the consumer goods or raw-materials sector, for example, cash flows are only weakly correlated with local government bond payments and are less volatile. Value a business in emerging markets
Understand estimates from different sources Estimates for country risk premiums from different sources usually fall into a very wide range, because analysts use different methods. But they frequently compensate for high estimates of country risk premiums by making aggressive forecasts for growth and ROIC.
An example is the valuation undertaken for a large Brazilian chemicals company. Using a local WACC of 10 percent, an enterprise value of 4.0 to 4.5 times EBITDA was determined. A second adviser was asked to value the company and came to a similar valuation—an EBITDA multiple of around 4.5—in spite of using a very high country risk premium of 11 percent on top of the WACC. The result was similar because the second adviser made performance assumptions that were extremely aggressive: real sales growth of almost 10 percent per year and a ROIC increasing to 46 percent in the long term. Such long-term performance assumptions are unrealistic for a commodity-based, competitive industry such as chemicals. Value a business in emerging markets
Be careful to avoid setting the country risk premium too high Make sure to understand the economic implications of a high country risk premium. A country risk premium for Brazil is far below the premiums of 5 percent and higher that analysts typically use. Value a business in emerging markets
One reason is that current valuations in the stock market do not support the discount rates implied by higher risk premiums. The trading multiples of enterprise value to the 2009 forecasted EBITA for the 50 industrial companies in the Bovespa, the Brazilian equity market index is estimated as follows:
- The median value for the multiple was 7.8 in September 2009. Value a business in emerging markets
- The implied WACC is estimated by means of a DCF valuation. The future long-term return on invested capital is set at 12 percent, approximately equal to the median historical ROIC for these companies from 2004 to 2008. Value a business in emerging markets
- Assuming future long-term inflation at 4.5 percent and real growth at 3.5 percent for the Brazilian economy as a whole, the WACC for the Brazilian market implied by the EBITA multiple of 7.8 is around 10.8 percent. Value a business in emerging markets
The WACC estimated with the CAPM previously described is around 10.0 percent7. This would imply a country risk premium for Brazil of around 0.8 percent. Of course, this is not a precise estimate; as the Brazilian market goes up and down, the implied WACC and country risk premium would change as well. But it does suggest a country risk premium that is far below the 5 percent that many analysts use.
The other reason for such a low country risk premium is that historical returns in the Brazilian stock market do not support a high premium. The average real-terms return on the Brazilian stock market between December 1994 and December 2008 was approximately 5.5 percent per year, far below the level that would support a substantial country risk premium.
Calculating and analysing the present values IFRS 13 Value a business in emerging markets
Given the estimates for cash flow and the cost of capital, the free cash flows for ConsuCo are discounted under the base case and the downside scenario.
The resulting present values of operations are shown below: Value a business in emerging markets
ConsuCo: Scenario DCF Valuation (R$ millions) IFRS 13 Value a business in emerging markets
Under each scenario, the valuation results are exactly the same for the nominal and real projections. The next step is to weight the valuation results by the scenario probabilities and derive the present value of operations. Finally, add the market value of the non-operating assets, and subtract the financial claims to get at the estimated equity value. The estimated equity value obtained for ConsuCo is about 32 R$ per share, given a 30 percent probability of economic distress.
ConsuCo’s share price, like the Brazilian stock market in general, has been quite volatile over recent years, as shown below: IFRS 13 Value a business in emerging markets
ConsuCo: Historical Share Price Development (R$) IFRS 13 Value a business in emerging markets
Source: Datastream. IFRS 13 Value a business in emerging markets
Thus, there is a need to be careful in comparing the valuation outcome with the current (October 2009) share price. The share price development of ConsuCo clearly shows the rally since the beginning of 2009, following the first impact of the turnaround. Value a business in emerging markets
Remember that the base case in the DCF model also assumes a recovery in sales productivity and growth performance. It is therefore not surprising that the DCF valuation comes out above the share price level of recent years. Obviously, any concerns around the continuation of results from the turnaround program would have significant implications for the DCF value. Value a business in emerging markets
In contrast to share prices in developed markets, share prices in emerging markets are not always reliable references for intrinsic value, for several reasons. First, free float is often limited, with large equity stakes in the hands of a small group of owners, leaving public shareholders with little or no influence. As a result, the share price in the market could well be below intrinsic value estimated using a DCF analysis. Also, liquidity in emerging-market stocks is often much lower than in developed markets. Share prices may not fully reflect intrinsic value, because not all information is incorporated in the market value. Finally, share prices in emerging markets are often much more volatile than in developed markets. The share price on any particular day could therefore be some way off intrinsic value.
ConsuCo has a primary listing on the Brazilian stock exchange. Turnover in the stock, as measured by the number of days to trade the free float, is not much different from typical levels in the United States and Europe. Still, because of the share price volatility, it is important to triangulate the DCF results with multiples and a country risk premium approach.
Triangulating with Multiples and Country Risk Premium Approach
For the ConsuCo example, a comparison of the implied multiple of enterprise value over EBITDA with those of peer companies is made. All multiples are forward-looking multiples over EBITDA as expected for 2009. See the comparison table below, the implied multiple from our ConsuCo valuation is significantly higher than for U.S. and European peers but at the low end of the range for Latin American peers. Given the higher growth outlook for ConsuCo in the Brazilian market compared with that of large established chains in the United States and Europe (partly because of the relatively low penetration of durable goods in Brazil), the higher multiple is not surprising.
ConsuCo: Multiples Analysis vs. Peers IFRS 13 Value a business in emerging markets
Relative to regional peers, ConsuCo is already very well established and geographically widespread. It also has somewhat more exposure than listed peers have to the lower-growth food segment. Hence, a multiple at the low end of the range is not unreasonable. Value a business in emerging markets
The last part of the triangulation consists of a valuation of ConsuCo using a country risk premium approach. The country risk premium for Brazil was estimated at around 0.8 percent. Discounting the business-as-usual scenario at the cost of capital plus this country risk premium leads to a value per share of 20 R$, significantly below the 32-R$ result obtained in the scenario DCF approach (more than 35 percent lower). The reason for this gap lies in ConsuCo’s cash flow profile, and it highlights why a scenario approach is preferable to using a discount rate reflecting a country risk premium. Due to ConsuCo’s high growth in the near term and corresponding investments, its free cash flows are negative for the first five years, pushing value creation forward in time. But the further ahead a company’s positive cash flows, the more those cash flows are penalized by the country risk premium approach: a markup in WACC cumulates over time, making long-term risk adjustment exert more downward pressure on present value than near-term adjustment. This does not happen in a scenario approach, because the scenario probabilities affect all future cash flows equally. If ConsuCo were to have a lower-growth outlook, the country risk premium approach would produce a valuation much closer to the valuation from the scenario approach.
Note that irrespective of ConsuCo’s cash flow profile, a risk premium of 5 percent (as is typically used in Brazil) would either result in unrealistically low valuations relative to current share price and peer group multiples, or require an unrealistically bullish forecast of future performance.
See also: The IFRS Foundation