Reading 43: Valuation in Emerging Markets

After about 4 days, I finally picked up my book again. Blame it on my Graduation excitement. Yeah- I’m an MBA now. 🙂

I did this reading from Schweser after seeing that the official reading is too long. I might come back to the official curriculum in case I’m having trouble solving questions. I worked out the concept checkers at the end of Schweser material and they are really good.

Main Concepts:

1. The real valuation approach discounts real cash flows at the real rate of return, while the nominal valuation approach discounts nominal cash flows at the nominal rate of return. But the value of the firm using both the methods will be almost the same.

2. Cash flow forecasting for real markets tends to be challenging because of the high inflationary environment. Three issues require particular attention-

• Income taxes are based on nominal earnings; so an estimation of nominal EBITA is required.
• Real NWC and Nominal NWC are not the same. We need to divide Nominal NWC by the inflation rate to arrive at the Real NWC. The change in the nominal NWC captures the flow effect, but the holding loss in real NWC is ignored. So, in an inflationary environment, the investment in Real NWC increases and the real FCF decreases.
• Nominal capital expenditures are difficult to calculate by simply calculating sales and related expenditures because of the high inflation. So, we need to calculate the real sales, real capital expenditures, real EBITDA and depreciation on a real basis.

3. FCF= NOPLAT+ Depreciation- Change in NWC- Change in Net Capital Expenditure

NOPLAT= EBITA- Taxes

4. Steps for valuing a firm in an emerging economy on a real and nominal basis are-

• Calculate the revenue, EBITDA, Invested Capital and EBITA on a real basis.

[Note: Invested Capital= Net PPE (End)+ NWC;

Net PPE (End)= Net PPE (Beg)- Depreciation +Capital Expenditure.

Depreciation is calculated by Dividing the Beg. PPE by the number of years.]

• Calculate the Revenue, EBITDA, Depreciation and EBITA on a nominal basis.
• Calculate the real NOPLAT
• Calculate FCF on a real and nominal basis.
• Estimate firm value in both real and nominal terms by discounting the real and nominal FCF at the real WACC and the nominal WACC. The nominal WACC is not the same every year because of the inflation rate. (1+nominal rate)= (1+real rate)(1+ inflation rate)

Effect on Financial Ratios: Generally the ratios in real terms are accurate and the ratios in nominal terms are incorrectly estimated. ROIC (Return on Investment Capital= NOPLAT/Beg. Invested Capital) is overstated in nominal terms. NWC/Revenue is correctly states in both real and nominal terms. Ratio of PPE/Revenue is generally understated in nominal terms.

5. There are two ways of incorporating emerging market risk in the valuation process- a. Adjusting the cash flows in a scenario basis b. Adjusting the discount rate by adding a country risk premium. Adjusting the cash flows has more support because of the following reasons-

• Country risks are diversiable
• Companies respond differently to country risk. (All companies might not use the same country risk premium. So it’s better to adjust the individual cash flows).
• There is no systematic method to calculate a country risk premium.
• When managers have to discuss emerging market risks and their effects on cash flow in scenarios, they gain more insights than they would get from country risk premium.

6. Calculation of WACC should follow these guidelines-

Risk free rate= 10 yr US Govt Bond Yield + Difference in inflation betn. both the countries

Beta= Industry beta from a globally diversified market index.

Market Risk Premium should be between 4.5-5.5% (long term average risk premium on a global market index)

Pre-tax cost of debt= Local Risk free rate + US credit spread on comparable debt

Marginal Tax Rate- Only taxes that apply to the interest expense should be included. Other taxes or credits should be modeled directly in the cash flows.

Some assumptions that are used while calculating WACC-

We have adopted the perspective of an international investor who has a diversified portfolio. As long as international investors have access to local investment opportunities, local prices will be based on an international cost of capital. Another assumption is that most country risks are diversifiable from the perspective of a global investor. We therefore need no addl. risk premium in the cost of capital when discounting cash flows.

7. When using the Country Risk Premium approach, we should keep the following points in mind-

Do not simply use the sovereign risk premium which is the difference betn. the long term US bond yield and a dollar denominated local bond’s yield with the same maturity. This is because this difference will reasonably approximate the country risk premium only if the cash flows of the corporation being valued moves closely in line with the payments on government bonds.

We need to understand estimates from different analyst sources because the underlying assumptions will vary. For eg- A high country risk premium might be used along with a very high growth rate and a low country risk premium might be used with a low growth rate. So the final value might still be the same.

We should not set the country risk premium too high. One way to do this is to compare the expected return using the CAPM Model with the historical real rate of return.