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In countries experiencing hyperinflation (an inflation rate of more than 25 percent per year), companies often report in year-end currency.3 They make adjustments to the income statements to reflect items, such as revenue, in year-end currency. So if the revenue were booked in July at the July currency, the reported revenues in the annual report will be restated at the year-end purchasing power. Otherwise, in high-inflation environments, the income statement items would not really be additive since they would be based on different purchasing power. The balance sheet only has adjustments to fixed assets, inventory, and equity; the accounts payable and receivable are already in year-end terms. As in inflation accounting valuations, revaluations of property, plant, and equipment need to be backed out of capital spending calculations.
Estimating Cash Taxes
In emerging markets, an accurate assessment of cash taxes can be quite challenging. An example is Brazil, which has had large and frequent changes to the tax code. In 1996, Brazil eliminated inflation accounting and reduced the corporate tax rate to 30.5 percent. In 1997, the government disallowed the deductibility of the social contribution tax, effectively increasing the tax rate to 33 percent. To make up for the loss of the tax shields that inflation accounting had generated, the government allowed companies to deduct interest on equity net of a withholding tax of 15 percent. Many other emerging markets have significant cash tax adjustments that need to be understood before you start a valuation.
Dealing with Exchange Rates and Inflation Rate Gaps
In many emerging market companies, the individual components of the cash flows are not denominated in the same currency. A substantial portion of a company's revenues and debt may be denominated in dollars, for example, while its expenses are primarily local. Consider an oil exporter. Its revenues are determined by the dollar price of oil while many of its costs (labor and local purchases) are determined by the local currency. Unless foreign exchange rates immediately adjust to inflation differentials (in other words, purchasing power parity holds), the company's operating margins and cash flows will deviate from their long-term trend.
It is important to keep two facts in mind when estimating the impact of changing exchange rates. First, over the long run, purchasing power does hold. In other words, exchange rates ultimately do adjust for differences in inflation between countries. Second, exchange rates can deviate from purchasing power parity by up to 20 to 25 percent for as long as ten or more years (although purchasing power parity adjusted exchange rates are enormously difficult to estimate).
3 Some companies will report in U.S. dollars to avoid this problem.
Exhibit 19.5 Brazilian PPP Adjusted Exchange Rates
For example, if you held $100 million of Brazilian currency in 1960, by 1998 it would have been worth less than one cent in U.S. dollars. Yet, on a purchasing power adjusted basis, the value of the currency didn't change as shown on Exhibit 19.5. In other words, if instead of holding $100 million of Brazilian currency, you held $100 million of assets in Brazil whose value increased with inflation, in 1998 your assets would still be worth about $100 million.
When developing your forecast, you first need to develop a perspective on whether the current exchange rate is over- or undervalued on a PPP basis and by how much. You can then estimate the impact of the over- or undervaluation on the profitability of the company. Finally, conduct a sensitivity analysis to assess the impact of the timing of the return to PPP. As you develop your forecast, remember your overall perspective about the economics of the business (in other words, what is the long-term sustainable operating profit margin and ROIC).
Incorporating Emerging Market Risks in the Valuation
The major distinction between valuing companies in developed markets and emerging markets is the increased level of risk. Not only must you account for risks related to the company's strategy, market position, and industry
dynamics, as you would in a developed market, but you must also deal with the risks caused by greater volatility in the capital markets, and macroeconomic and political environments. Emerging market risks to consider include inflation, macroeconomic volatility, capital controls, political risk, war or civil disturbances, regulatory changes, poorly defined or enforced contract or investor rights, and corruption.
Pros and Cons of Where to Incorporate Country Risks
There are many opinions on how to incorporate these additional risks in a DCF valuation, and whether to include them in the cash flows (the numerator) or the discount rate (the denominator). Accounting for these risks in the cash flows through probability-weighted scenarios provides a more solid analytical foundation and a more robust understanding of the value than incorporating them in the discount rate.