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The basics of estimating a DCF value are the same in emerging markets as elsewhere, so we will focus in this chapter on four issues specific to emerging markets:

1. How to factor inflation into the financial analysis and cash flow forecasts.

2. How to deal with exchange rate and inflation rate gaps.

3. How to incorporate special emerging market risks into the valuation.

4. How to calculate the cost of capital in emerging markets.

Effects of Inflation on Financial Analysis in Emerging Markets

High and unpredictable levels of inflation are often an important feature of emerging markets. Inflation distorts the financial statements, making year-to-year comparisons and ratio analysis difficult. Forecasting is also complicated.

In most countries, financial statements are not adjusted to reflect the effects of inflation. This means that assets and liabilities are recorded at historical cost and are not revalued to current currency units. This creates distortions in net property, plant, and equipment, and inventories (so-called nonmonetary assets) relative to other balance sheet items and the income statement. Other assets and liabilities (various types of receivables and payables) do not need restating. Some countries (for example, Colombia, Mexico, and Venezuela as of the end of 1999) require adjusting reported financial statements for inflation. At the end of this section, we briefly discuss this issue.

For companies operating in high inflation environments, we strongly recommend that valuations be done in both nominal and real (constant currency) terms. When done properly, the resulting value should be identical. (Nominal cash flows discounted at a nominal rate should equal the corresponding real cash flows discounted at the corresponding real rate.) By applying both methods, you know that you have properly handled the effects of inflation.

Rationale for Valuing in Both Real and Nominal Terms

The major differences and shortcomings of doing a valuation in nominal and real terms are summarized in Exhibit 19.2. In short, doing the valuation in real terms makes it virtually impossible to calculate taxes correctly (taxes are calculated based on nominal financial statements) and also can lead to errors in the cash-flow effects of working capital changes. The downside of using the nominal cash flows is that ratios, such as the ROIC and property, plant, and equipment to revenues are often meaningless in high inflationary environments. Another downside of the nominal DCF valuation is that the continuing value formula needs to incorporate the real growth and expected returns to reflect the true economics of the business in the continuing value period.

The example in Exhibit 19.3 illustrates the need for both nominal and real forecasts. This company does not grow in real terms and the annual inflation rate is 20 percent. The nominal EBITDA grows with inflation and the unadjusted real-cash flows are flat. In the nominal case, the depreciation grows much slower than the EBITDA so that depreciation shelters less and less of the growth of nominal EBITDA from taxes. The working capital requirements in the nominal case, however, continue to grow with inflation, which erodes the cash-flow value. This effect is not reflected in the real cash flows if looked at from changes in the balance sheet. To be accurate, the real cash flows need to reflect the actual tax shields and the working capital requirements. These can only be estimated from the nominal accounts and then translated, as in the third example, where the translations from the nominal accounts are highlighted. If a simple real

Exhibit 19.2 Comparing Real vs. Nominal DCF Valuation f-\

Real Nominal Impact on value

Calculates meaningful ratios Captures actual taxes Captures actual working capital

Real will overstate value when working capital/revenues >0

Real allows check on whether forecast is realistic

Real will overstate value

No adjustment required to continuing value lormula

Using ordinary cv formula for nominal will overstate value

Enables realistic capital expenditure forecasts

Nominal approach typically overestimates investment in capital spending

Exhibit 19.3 Inflation Effects on Financial Statements

BCJI Ntll'lAl iiri working capital

Beg net PPE Depreti.ilion

< Ml expenditure

EndnelPPC

Nomma I

Unadjusted forecasted real

Real translated from nominal1

Nomma I

Unadjusted forecasted real

Real translated from nominal1

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