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This chapter showed how to apply the DCF valuation approach to companies outside the United States. The approach is the same as in the United States. As expected, you need to understand and reflect local accounting and tax in your analysis, but the adjustments are straightforward. The cost of capital approach is also the same around the world, although estimation of some of the parameters (particularly market risk premium) can be controversial. We recommend using a common market risk premium around the world as the capital markets were substantially integrated by the end of the twentieth century.
19-Valuation in Emerging Markets
As the world economy globalizes and capital becomes more mobile, valuation is gaining in importance in emerging markets for privatization, joint ventures, mergers and acquisitions, restructuring, and value-based management. Yet valuation is much more difficult in these environments because the risks and obstacles that companies face are greater than in developed markets. Major risks and challenges include high levels of macroeconomic uncertainty, illiquid capital markets, controls on the flow of capital in and out of the country, and high levels of political risk.
There is no agreement on how to address these challenges among academics, investment bankers, and industry practitioners. Methods vary considerably and often involve making arbitrary adjustments based on limited empirical evidence and gut feel. In the face of this lack of consensus, we recommend a pragmatic approach of comparing estimates of the value from three methods as summarized in Exhibit 19.1. Our primary approach is to use discounted cash flows with probability-weighted scenarios that explicitly model the risks that the business faces. The value obtained from this approach is then compared to a DCF approach with a country-risk premium built into the cost of capital and a valuation based on comparable trading multiples.1
Special thanks to our colleague Mimi James, who co-wrote this chapter.
1 Note that when using the DCF approach with a country-risk premium built into the discount rate, cash flows should not be reduced by the country risk already in the discount rate. We sometimes refer to this approach as discounting ''promised" or "hoped for" cash flows rather than "expected" cash flows.
Exhibit 19.1 Compare Alternative Methods
The basics of estimating a DCF value are the same in emerging markets as elsewhere, so we will focus in this chapter on four issues specific to emerging markets:
1. How to factor inflation into the financial analysis and cash flow forecasts.
2. How to deal with exchange rate and inflation rate gaps.
3. How to incorporate special emerging market risks into the valuation.
4. How to calculate the cost of capital in emerging markets.
Effects of Inflation on Financial Analysis in Emerging Markets
High and unpredictable levels of inflation are often an important feature of emerging markets. Inflation distorts the financial statements, making year-to-year comparisons and ratio analysis difficult. Forecasting is also complicated.
In most countries, financial statements are not adjusted to reflect the effects of inflation. This means that assets and liabilities are recorded at historical cost and are not revalued to current currency units. This creates distortions in net property, plant, and equipment, and inventories (so-called nonmonetary assets) relative to other balance sheet items and the income statement. Other assets and liabilities (various types of receivables and payables) do not need restating. Some countries (for example, Colombia, Mexico, and Venezuela as of the end of 1999) require adjusting reported financial statements for inflation. At the end of this section, we briefly discuss this issue.
For companies operating in high inflation environments, we strongly recommend that valuations be done in both nominal and real (constant
currency) terms. When done properly, the resulting value should be identical. (Nominal cash flows discounted at a nominal rate should equal the corresponding real cash flows discounted at the corresponding real rate.) By applying both methods, you know that you have properly handled the effects of inflation.
Rationale for Valuing in Both Real and Nominal Terms
The major differences and shortcomings of doing a valuation in nominal and real terms are summarized in Exhibit 19.2. In short, doing the valuation in real terms makes it virtually impossible to calculate taxes correctly (taxes are calculated based on nominal financial statements) and also can lead to errors in the cash-flow effects of working capital changes. The downside of using the nominal cash flows is that ratios, such as the ROIC and property, plant, and equipment to revenues are often meaningless in high inflationary environments. Another downside of the nominal DCF valuation is that the continuing value formula needs to incorporate the real growth and expected returns to reflect the true economics of the business in the continuing value period.