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

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.

Four practical arguments support this view. First, most country risks such as expropriation, devaluation, and war are largely diversifiable (though not entirely, as the economic crisis in 1998 demonstrated). Finance theory clearly indicates that the cost of capital should reflect only nondiversifiable risk. Diversifiable risk is better handled in the cash flows. Nonetheless, a recent survey showed that managers generally add some risk premium to the discount rate to adjust for these risks.4 However, more and more companies are building the risks into the cash flows.

Second, many country risks don't apply equally to all companies in a given country. For example, banks are more likely to be nationalized than retailers; or some companies may benefit from a devaluation (raw materials exporters) while others will be damaged (raw materials importers). Applying the same risk premium to all companies in the country would overstate the risk for some and understate it for others.

Third, country risks tend to be one-sided (only down). It is much easier to build one-sided risks into cash-flow scenarios than discount rates. Most attempts to build risk into the discount rate are ad hoc or based not on equity risk but the credit risk of the country. A common approach is to add a country-risk premium equal to the difference between the interest rate on a local bond denominated in U.S. dollars and a U.S. government bond of similar maturity. In many situations, equity investments in a company in the country will actually be less risky than investing in government bonds. For example, the bonds of YPF (the Argentine oil company) carry lower yields than Argentine government debt. In addition, equity investments carry potential upside risks, while bonds carry only downside risks.

4 T. Keck, E. Levengood, and A. Longfield, ''Using Discounted Cash Flow Analysis in an International Setting: A Survey of Issues in Modeling the Cost of Capital," Journal of Applied Corporate Finance, Volume 11, number 3, Fall 1998.

Finally, we find that having managers discuss these explicit risks and their effect on cash flow provides more insights for managers than a ''black box" addition to the discount rate. By identifying specific factors that have a large impact on value, managers can better plan to mitigate these risks.

In an effort to test whether the equity market actually builds a large risk premium into the valuation of emerging market companies, we valued a small sample of Brazilian companies. In our test, we forecasted cash flows using published investment banking reports that had at least three years of forecasts and were written within one month of the date of our market valuation (April 10, 1999). For the years after the explicit forecast in the reports, we assumed the same performance ratios to drive cash flow and used a perpetuity formula (NOPLAT/WACC) to estimate the continuing value after year 10. We discounted these cash flows using an industry-specific global cost of capital, adjusted for capital structure that included an inflation differential for Brazil versus the United States but no country-risk premium. (The method for estimating the industry-specific global cost of capital will be discussed in the next section.)

We found that the DCF values were extremely close to the market values (Exhibit 19.6). This is not an exhaustive sample and does not definitively prove that there is no country-risk premium in the Brazilian market. But it suggests that additional country-risk premiums in the range of 4 percent to 9 percent are not supported by the market prices for equities. If these

Exhibit 19.6 Market versus DCF Value for Sample of Brazilian Companies

Cash Builder The Prices

premiums were included in the cost of capital, the DCF values would be 50 percent to 90 percent lower than the market values. Incorporating Risks in the Cash Flows by Building Integrated Scenarios

When constructing scenarios in emerging markets, company-specific and industry scenarios should be aligned with the macroeconomic scenarios. Start with the macroeconomic scenarios because they influence industry and company performance.

The major macroeconomic variables that need to be forecasted are GDP growth, inflation rates, foreign exchange rates, and interest rates. These items must be linked in a way that reflects economic realities. For instance, GDP growth and inflation are important drivers of foreign exchange rates. When you construct a high-inflation scenario, foreign exchange rates should reflect this inflation in the long run because of purchasing power parity.

Next, determine how each of the components of the cash flow is driven by changes in the macroeconomic variables. Link these items to the macroeconomic variables, so that when the macroeconomic scenario is changed the cash-flow items adjust automatically.

After the macroeconomic variables are linked, think about industry scenarios. Constructing industry scenarios is basically the same in emerging markets as in developed markets, with a few variations. One difference is that industries in emerging markets may be more driven by government actions. Another difference is the dependence on markets outside the company's home country for either revenues or inputs. When constructing the model, make sure that the industry scenarios take the macroeconomic environment into consideration.

An example of a recent outside-in valuation of Pao de Ajucar, a Brazilian retail grocery chain, demonstrates how such scenarios can be built. In this example, Merrill Lynch devised three macroeconomic scenarios in September

Exhibit 19.7 Scenarios—Pao de A^ucar

Macro economic assumptions, 1999

Base case

International support and fiscal reform

Austerity Devaluation

Protracted higher interest Dramatic devaluation rates and continued volatility with results similar to with unemployment austerity scenario rising to 14%

1999 year end FX rate Average interest rates Real GDP growth Inflation

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Financial End Game

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