There’s no denying the appeal of investing in emerging markets. Not only are emerging economies growing faster than developed ones, but they also now account for 85.9 percent of the world’s population and 57.5 percent of its GDP.
But there’s no sugarcoating the uncertainties, either. It’s hard enough for business leaders to forecast cash flows accurately and estimate cost of capital amid fluctuations in foreign currency and potential increases in inflation, even when valuing companies that operate in traditional, developed economies. Emerging markets present additional risks—extreme economic contraction, for instance, or unexpected government actions such as asset appropriation. These risks vary by country and may affect different businesses in different ways.
Given these uncertainties, how should business leaders approach valuations in emerging markets as they consider making new investments or re-upping on existing ones?
Some academics, investment bankers, and industry practitioners believe it is necessary to incorporate an additional country risk premium in the cost of capital.
Our research and experience in the field suggest that would be a mistake. Business leaders can rely on the same valuation principles and approaches they would use to assess investments in developed markets. Tried-and-true valuation principles do not become any less valid in emerging markets. In fact, under high uncertainty, they can be even more essential.
The premium puzzle
Since investing in emerging markets can be riskier than investing in developed ones, why not simply add a country risk premium to the discount rate to account for the circumstances? There are several reasons why this logic is flawed.
Risk is a relative concept
First, consider that the very concept of risk is both relative and circumstance-dependent. Often, practitioners’ added risk premium is based on the government’s borrowing rate relative to a benchmark, such as the borrowing rates for the US government. But the riskiness of lending to a government may have little to do with the risk of investing in a business in that country. A company may have a cost of equity that is lower than the interest rate on the government debt in the country. Consider the riskiness of a consumer-packaged-goods (CPG) producer in an emerging market versus the government debt of that country. The CPG producer may experience a large drop in earnings during an economic crisis, but its earnings would likely spring back relatively quickly. And in contrast to the political environment facing banks and mining or energy companies, CPG businesses face little risk of appropriation by the government.
Another thing to note: it’s not extraordinary for governments to default on debt, or come close to doing so. Since 1990, Russia and Argentina have each defaulted, and Greece required bailout loans from the International Monetary Fund and European Central Bank multiple times. The cost of debt for some companies may also be lower than that of their government, as is the case in Brazil, where a number of companies’ debt is rated investment grade while the government’s is not.
Furthermore, it is illogical to apply the same risk premium across all industries within a given country. Between 2013 and 2018, returns on ten-year government bonds in Brazil were more volatile than those of the beverage company Companhia de Bebidas das Américas (Ambev) and less volatile than those of major Brazilian banks. Additionally, some companies, such as raw-materials exporters, might benefit from a currency devaluation while others, such as raw-materials importers, typically suffer when devaluations occur.
Premiums are often set too high
Additional country risk premiums are often set too high, which can make good projects seem unattractive or lead to overcompensation when projecting future performance. Consider the valuation of a large Brazilian chemical company: using a local weighted average cost of capital (WACC) of 10 percent, an analyst reached an enterprise value of 4.0 to 4.5 times earnings before interest, taxes, depreciation, and amortization (EBITDA). A second analyst was asked to value the company and came to a similar figure—an EBITDA multiple of around 4.5—despite using a very high country risk premium of 11 percent on top of the WACC. The results were similar because the second analyst made performance assumptions that were far too aggressive: real sales growth of almost 10 percent per year and a return on invested capital (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.
In another, broader set of analyst forecasts from 2015 to 2018, 30 percent of industries were expected to achieve growth rates of more than 20 percent, while in the United States, only 5 percent were expected to achieve similar results. It’s hard to imagine 30 percent of industries growing more than 20 percent per year.
Actual performance is misrepresented
Our research also shows that there isn’t much of a country risk premium built into the valuation of stocks in some emerging markets. If there were a substantial country risk premium, we’d expect price-to-earnings ratios (P/Es) to be much smaller than they are.
In Brazil, for instance, many valuations over the past decade have incorporated country risk premiums of 3 to 5 percent, plus an inflation differential (compared with US companies) of about 2 to 3 percent. That leads to a cost of equity of 15 to 18 percent. If we assume a P/E of 13 times,
with some reasonable assumptions about cost of equity, marginal return on equity, and inflation,
one would have to believe that the businesses would need to grow at 8 percent to justify those valuations. But 8 percent real growth in perpetuity is clearly unrealistic.
Of course, these results are highly sensitive to small changes in some of the assumptions. The key point is that it is very difficult to reconcile current P/Es with a high country risk premium. The results are further borne out by an additional analysis we conducted, bridging the US S&P 500 Index to Brazil’s Bovespa Index. These findings suggest that differences in multiples come almost exclusively from performance rather than additional country risk (Exhibit 1).
The scenario-based solution
It’s all too easy to underestimate the impact that even a small country risk premium has on valuations. Macro analyses can mask a wide variation in P/Es across economies. But that’s where the scenario discounted-cash-flow (DCF) approach proves its mettle: it assesses risks based on company-specific factors and tests what the effects of those risks would mean to the business being valued.
At a minimum, business leaders should model two scenarios. The first should reflect cash flows that could develop under “business as usual” conditions—for instance, in the absence of major economic distress. The second should reflect cash flows that could develop if one or more emerging-market risks materialize.
Consider the valuation of a European factory and that of an emerging-market factory; both have a similar outlook except for the emerging-market risk. An analysis shows that the cash flows for the European factory could grow steadily at 3 percent per year into perpetuity. By contrast, the cash flows for the factory in the emerging market could grow similarly under a business-as-usual scenario, but there is a 25 percent probability of economic distress, which could result in cash flows that are 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 their assumed probabilities. The resulting value of the emerging-market factory (€1,917) is clearly below the value of the European factory (€2,222), using a WACC of 7.5 percent (Exhibit 2).
Exploring different scenarios forces managers to discuss emerging-market risks and their effect on cash flows under realistically conceivable circumstances, thereby gaining more insights than they would from a simple, arbitrary addition to the discount rate. In this way, managers can identify the specific factors with the largest impact on value and plan to mitigate these risks.
Tying it all together
Scenario analyses are an essential part of valuing any investment in an emerging market, but they are only part of the story. Business leaders operating in emerging markets face unique challenges in estimating the cost of equity, the after-tax cost of debt, and the proper cost of capital, which should generally be close to a global cost of capital adjusted for local inflation and capital structure.
Some critical information and data (for example, in estimating betas) may be missing. Business leaders must be flexible as they assemble the information that is available, piece by piece. And they must bear in mind that 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. In Argentina during the economic and monetary crisis of 2002, for instance, the short-term inflation rate was 30 percent. This would not have been a reasonable rate for estimating the cost of capital long term, because such a crisis should not have been expected to last forever. In such cases, it is best to estimate the cost of capital year to year, following an underlying set of basic monetary assumptions.
Ultimately, the best practice for practitioners conducting valuations of emerging-market investments is to triangulate the results of their scenario analyses with a comparable, forward-looking multiples approach and a DCF using a realistic country risk premium, grounded in the country’s historical probability of economic crises and the effect of those crises on that specific industry. For instance, our analyses revealed that even severe turmoil rarely leads to a loss of all cash flows for consumer-goods companies in one emerging-market economy, which suggests a country risk premium of 1 to 2 percent is more realistic than common estimates of 3 to 5 percent, or higher.
To value companies in emerging markets, it’s best to stick with principles that apply in developed and emerging economies alike. In particular, adding an extra country risk premium to the cost of capital doesn’t add insight; it obscures it. There’s uncertainty—and opportunity—enough in emerging markets without adding guesswork to the equation.