Today’s world is more connected than before. With the evolution of science and technology, the global economy has become on one another. This interdependence means that companies that continue businesses in emerging economies are now easily accessible to investors and consumers from other nations.
With the increase in growth of emerging economies like Brazil, India, China and South Africa, investors are now looking at options to diversify their portfolios by including stocks from these markets.
Understanding the Evolution of Emerging Markets
The concept of emerging markets came into existence when Nixon’s administration started engaging in rapprochement with China and as Soviet nations started breaking away from U.S.S.R. to abandon the socialist concept. As these new countries started integrating themselves with global structures like World Trade Organization and International Monetary Fund, they transformed themselves into emerging markets. Most of these countries relied on resource extraction and secondary industries like manufacturing. But at the turn of the 1980s-1990s, the focus was more on country selection and the purchase of public-listed banking and telecommunication companies in those selected countries.
In the present world scenario, one of the biggest challenges that investors face is the proper evaluation of companies that work in emerging market economies. So, let’s take a look at some common approaches and factors that need to be accounted for when placing value on emerging market companies.
Discounted Cash Flow Analysis
The concept of placing value on a firm in an emerging market may seem challenging. Still, the process is very similar to the evaluation of a company from a developed economy. The primary basis of this evaluation is Discounted Cash Flow Analysis. The idea behind DCF analysis is to estimate the amount an investor would receive from making investments that are adjusted for the time value.
Even though these concepts are the same, there are multiple factors to consider when analyzing emerging markets. These include Exchange rates, interest rates, and inflation estimates. These are some of the significant concerns when investigating newly emerging market firms, especially when these markets are highly volatile.
Exchange rates are mostly considered to be irrelevant by some analysts. But, the local currency in emerging market countries can differ significantly in relation to established currencies like the dollar. They generally tend to follow the nation’s Purchasing Power Parity (PPP). So, any change in the exchange rate will have a minimal effect on future domestic business estimations for emerging market firms. But, a sensitivity analysis will help indicate if the foreign exchange rates impact the fluctuations in local currency.
But again, inflation plays a significant role in the evaluation, especially for firms operating in high-inflation settings. Any future cash flow can be estimated based on both the nominal and real terms that neutralize the effect of inflation on the DCF estimate in emerging market firms.
When estimating the future cash flow in both real and nominal terms and discounting them at appropriate rates, the derived firm values are reasonably close when inflation is appropriately accounted for. Making reasonable adjustments in the numerator and denominator to the DCF equations helps remove the impact of inflation.
[ Check out What is Portfolio Management Strategies? ]
Adjustments That Are Made to Calculate DCF in Emerging Markets
1. Capital Costs
One of the significant hurdles in deriving free cash flow estimates in an emerging market is estimating a firm’s capital cost. The firm’s cost of equity and debt and the actual capital structure have inputs that can be pretty challenging when making estimations in emerging markets.
One of the biggest problems in estimating equity costs is inherently based on the risk-free rate, as emerging market bonds cannot be declared as riskless investment options. So, it is better to add the inflation rate differential in the local economy and a developed nation and to add the long-term bond yield of the developed country.
2. Debt Costs
The debt cost can be calculated using the comparable spread from a developed nation on similar debt issues to those affecting the company in question. Adding to the risk-free rate will provide investors with an acceptable pre-tax cost debt. This is a necessary input required for the calculation of the overall debt cost of the company. This method factors in the assumption that the risk-free rates of an emerging market are realistically not risk-free.
Again, the industry average should be taken into consideration to measure the capital structure. If no local industry averages are available, then a regional or global standard is the nearest alternative.
3. Weighted Average Cost of Capital
Including a country risk premium to a firm’s Weighted Average Cost of Capital helps improve the DCF. This, in turn, helps improve the appropriate discount rate when using the nominal figures required to discount the firm’s future cash flow. Overall, a country’s risk premium should be included in that it fits with the overall economy and firm.
One significant rule when choosing the country risk premium is to look at the premium in terms of the Capital Asset Pricing Model. This helps make sure that the historical returns of the company’s stocks are accounted for.
[ Also See What is Risk Tolerance? ]
4. Peer Comparison
When making a thorough evaluation, just like other companies from developed economies, there should be a comparison of the firm with its industry peers. Evaluating the company against its competitors provides a clear picture of how the business is functioning compared to its peers. This is especially relevant when the peers compete with a similar economy.
Conclusion
Valuation of firms from emerging marketplaces can be quite daunting. But the basic valuation approach used for developed economy businesses is applicable to emerging market companies with minor adjustments. Nations like India, China, and others are growing rapidly and leaving their mark on the global economy, so valuing companies from multiple countries is essential to building a global portfolio.
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Vishnu
Founder & Managing Director of Investor Diary
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