Emerging Capital Markets AG907 M.Sc. Investment & Finance - PowerPoint PPT Presentation

Emerging Capital Markets AG907 M.Sc. Investment & Finance M.Sc. International Banking & Finance Lecture 4 – Valuation in Emerging Capital Markets I g n a c i o R e q u e j o – G l a s g o w , 2 0 1 0 / 2 0 1 1

Overview of Lecture 1. Introduction 2. Basic Valuation Approaches 3. Valuation Process 4. Does the Choice of Model Matter? Empirical Evidence – Valuation in Emerging Markets E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 1

1. Introduction Characteristics of EMs affect valuation assumptions ⇒ Adjustment in valuation methods ⇒ Given foreign currencies Two different general valuation approaches Valuation of EM investments ⇒ Steps investors should follow E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 2

2. Basic Valuation Approaches Two discounted cash flow (DCF) valuation approaches for valuation of investments in foreign country ⇒ Example Approach A. • Peso flows converted to dollars (forecast of forward peso/dollar exchange rates) • Dollar CFs discounted using dollar weighted-average cost of capital (WACC) • Estimation of dollar WACC must reflect • Systematic risk of target industry • Local equity market & country risk E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 3

2. Basic Valuation Approaches Approach B. Local CFs discounted using local WACC ⇒ Local NPV • for investment • Local NPV converted into dollar NPV using spot peso/dollar exchange rate Each approach has Strengths & Weaknesses ⇒ choice • Relative confidence in local capital market data • Relative confidence in theoretical equilibrium in international currency & capital markets E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 4

2. Basic Valuation Approaches Convert CF from Pesos to Dollars Peso CFs US Dollar CFs Approach A Discount at Discount at US Peso WACC Dollar WACC Approach B Peso NPV US Dollar NPV Convert NPV from Pesos to US Dollars E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 5

2. Basic Valuation Approaches Characteristic Approach A Approach B • PPP & IRP hold • Local capital market has good • Inflation forecasts in pesos & data availability & quality Key features dollars appropriate • Local capital costs are free-market • Country risk premium estimate yields appropriate • Theoretical rigour • Simplicity Strengths • More reliable capital market • Translation at current spot rates information from DMs • Availability & quality of local data • PPP & IRP do not always hold • Betas not available for many • Long-term forecasting of inflation stocks in EMs difficult Weaknesses • Many interest rates administered • Assumes US interest rates by central banks & do not reflect consistent with forward inflation expectations or require peso/dollar exchange rates real rates of return E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 6

2. Basic Valuation Approaches Approach A. • Future CFs converted from foreign to home currency before discounting Forward exchange rates beyond 3 years rare! ⇒ Rely • on exchange rate forecasts or interest rate parity (IRP) IRP ⇒ No arbitrage in currency markets; fluctuations in • exchange rates depend on ratio of local & foreign inflation rates Approach B. • Use of local market data to use a local discount rate • Confidence in local data to estimate local NPV! E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 7

3. Valuation Process Three separate steps 1. Evaluate general investment environment 2. Forecast CFs of investment 3. Estimate cost of capital to discount CFs E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 8

3.1. General Investment Environment Intangible attributes of particular market that modify risk of investing in it Investors should consider five key attributes • Information environment • Market integration • Political risk • Rule of law, corruption, corporate governance & minority shareholders protection • Social issues & culture E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 9

3.1. General Investment Environment Information environment Valuation of companies ⇒ Availability of accurate & • reliable information Data sources for foreign investors ⇒ Accounting • statements & financial analysts projections • Quality of information environment in which company operates • Investors must adapt to information available for each market E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 10

3.1. General Investment Environment Market integration/segmentation • Local market integration with global markets is important ⇒ Fundamental assumption in valuation: that investors can engage in arbitrage If arbitrage is not possible ⇒ Reference point for • investors is local (rather than global) cost of capital • Integration affects discount rate used in EMs E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 11

3.1. General Investment Environment Political risk Local government intervention ⇒ Effect on asset value • Different ways of intervention ⇒ Regulation, punitive • tax policies, restrictions on cash transfers, etc. • Outright expropriation of assets of foreign companies vs. lack of protection when breakdown in order occurs Official corruption ⇒ Alternative form of taxation • Investor’s perception about political risk ⇒ Estimation • of CFs & exchange rate (CPI) E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 12

3.1. General Investment Environment Rule of law, corruption, corporate governance & minority shareholders protection • Valuation depends on protection of minority investors rights ⇒ Lower share prices if expropriation expected Premiums for control will tend to be higher ⇒ Access • to higher private rents (private benefits of control) • More corrupt environment in EMs than DMs E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 13

3.1. General Investment Environment Social issues & culture • Some business cultures endorse certain principles • Nepotism • Paternalism • Discrimination • Charitable giving • Official corruption • Tax evasion • Reliance on government assistance E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 14

3.1. General Investment Environment Adjustment in valuation to account for EMs attributes ⇒ Mutually exclusive to avoid double-counting 1. Adjust CFs downward 2. Adjust discount rate upward Comparing bond yields ⇒ Bondholders premium • Bonds denominated in same currency (US dollars) • Similar class of asset (e.g., sovereign bonds of the respective government, same corporate bond rating) • ‘Free market’ yields (not s.t. government intervention) E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 15

3.2. Estimating Cash Flows Important considerations when estimating CFs in EMs • Inflation • Foreign currency exchange rates • Tax rates • Timing of remittance of cash • Accounting principles E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 16

3.2. Estimating Cash Flows Inflation Wide variation in inflation rates across countries ⇒ • applying inflation rate of US, OECD countries, world economy! • Inflation assumptions for CFs & discount rate • Consistent assumptions through valuation process E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 17

3.2. Estimating Cash Flows Foreign currency exchange rates ⇒ • Significant variation during investment lifetime Forecast exchange rate behaviour For long-term investments ⇒ Use IRP coupled with • inflation expectations (to estimate future exchange rate behaviour if freedom to move capital across borders) No freedom ⇒ Take into account capital controls, other • macroeconomic policies that prevent capital from flowing to most profitable opportunities E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 18

3.2. Estimating Cash Flows Tax rates • Affects both forecasted CFs & discount rate • Consistency through valuation process • Marginal tax rate appropriate to country where CFs are generated Consider tax system of investor’s country ⇒ E.g., are • investors exempt from taxation of foreign income? E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 19

3.2. Estimating Cash Flows Timing of remittance of cash • Possibility of no free movement of capital across borders ⇒ E.g., limits in outbound movement of cash Timing of remittance of cash can affect taxation ⇒ • E.g., some countries tax foreign income when it is received (rather than earned) • Timing of the return of cash should be explicitly modelled E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 20