As seen in Business Valuation Update
Editor’s note: There is relatively little guidance on the valuation of multinational companies. There are models that can be used, but they should not be used blindly. The inputs to the models must be carefully considered because there is no one-size-fits-all methodology. The author has developed a framework designed to break out of models and develop a more realistic valuation and cost of capital based on real world dynamics. This article is a follow-up to the author’s “Getting Your Head Out of the Model: Due Diligence and Developing International Cost of Capital,” originally featured in the May 2006 issue of Business Valuation Update.
Appraisers valuing a multinational company (MNC) should expand their due diligence process to solicit information from company management about the specific effects of operating in their particular location. Additionally, business valuators should review country-risk-and-return and country-risk ratings.
I recommend that you break down your due diligence into these key areas of investigation: company-country-currency-sector (CCCS). In this article, I will discuss each of these and give an example of using the CCCS framework in practice. Also, I will cover developing a weighted average cost of capital (WACC) and recommend a technique for considering a large portfolio of countries.
Company. Due diligence on a company considers its history and outlook as well as where it sources its inputs, and how and where it produces its products or provides its services. It looks at the company’s competitive landscape, barriers to entry, and how it uses marketing to generate sales. Inherent in studying a company is an appreciation for its location and its end markets and the risks associated with these elements. Special focus on the industry (sector) and currencies that are involved in its normal operations is recommended.
Appraisers use comparable data (comps) and benchmark a subject entity with its comps, focusing on the attributes of growth, risk, and profitability (GRP) to ensure the market prices of comps to the pricing of a company has been effectively bridged. GRP contributes to the story from a qualitative and quantitative perspective in terms of why an EBITDA or price/revenue multiple is selected for the subject entity being valued.
Country. Ultimately, the valuation of an MNC should consider GRP and CCCS. The risk analysis for an MNC includes knowing what countries the subject company sells to and where the major production assets are located. The astute views of Dr. Aswath Damodaran (Stern School of Business, New York University) and legendary investment manager Gary Brinson are relevant to this discussion. In effect, these experts suggest that the location of the company’s headquarters or where the company’s publicly traded stock is exchanged is not nearly as important (if at all) as where the company generates its sales or does business.
The country analysis requires obtaining recent information on a specific country. There are numerous sources for reference, some free and some for a fee. Examples of free information:
These websites won’t give you a cost of equity, but most will describe the current economic conditions and/or provide some comparative ratings of a country versus the world.
Dr. Damodaran’s website, on the other hand, is free and provides a means of estimating a cost of equity and a cost of debt, considering a variety of data including local currency sovereign ratings from Moody’s (or S&P equivalent) and credit default swap (CDS) spreads by rating. For more details, download the Excel spreadsheet that contains these data from www.stern.nyu.edu/~adamodar/pc/datasets/ctryprem.xls.
Currency. When we speak about risk, we refer to “total risk” and, equivalently, what would be an estimated total return that a willing buyer (IRS definition of value) or average market participant (FASB definition of value) judges to be applicable. Total return includes the elements of yield plus capital gain. Inherent in the total return is an understanding of what currencies are involved.
When investing in nondomestic businesses, the MNC is exposed to nondomestic currencies. Currency risk is a significant component of total risk. Evidence exists that currency risk may be 50% of total incremental country risk or more. According to an article titled “Does Emerging Market Exchange Risk Affect Global Equity Prices” by Francesca Carrieri, Vihang R. Errunza, and Basma Majerbi (2004), “The price of EM currency risk is significant and time-varying for a large number of assets from developed and emerging markets. Total currency premia are also economically significant as, on average, they represent about 40 percent of the total premium in absolute value across all global assets. Therefore currency risk is an important risk factor in pricing both emerging market and developed market assets.”
Professor Campbell Harvey (Duke University) has written to me on the significance of currency risk: “I stated in presentations and in my course material that, for a high-risk market, it is likely that about half of the risk is related to currency.”
The impact that currency risk has on total risk is also highlighted in a recent article titled “International Equities: Currencies Matter,” by Axel G. Merk, Merk Investments, May 8, 2014. “When investing in international equities, the return stream generated can be broken into equity returns and currency returns. As the chart in Exhibit 1 shows, between 30% and 50% of monthly equity index returns, when measured in U.S. dollars, were attributable to currency fluctuation.1
The impact of currency risk works both ways—on the upside as well as on the downside. In a month where the local country’s stock market moved up, it is possible that a good portion of the gain may be attributed to currency appreciation. Similarly, in a down month, a good portion of the loss may be attributed to currency depreciation.
Similarly, currency volatility can impact total return. The MNC may be subject to foreign exchange gains or losses as a result of its portfolio of offshore businesses, which have different functional currencies. For an MNC, the purchase or sale of a division that is located in a developing market will likely involve exposure to local country currency volatility. Or it could be that offshore operations are involved in a major global industry and product sales generate hard forms of currency such as dollars or euros.
The point is that currency is a major contributor to risk, but it depends on the nature of the MNC’s business. If the subject MNC is completely exposed to individual local country currencies from emerging markets, it may have a high degree of risk. But if it is gathering hard currency from various offshore affiliates, the perception of risk is somewhat mitigated.
Also consider the form of the hard currency involved. Today, dollars or euros are considered to be safe havens. But what about the future? Will these currencies give way to Chinese yuan/renminbi? Or will there be a global basket of currencies or goods?
The idea that the U.S. dollar may be replaced in global trade settlements is not that farfetched. Consider a recent article, “Welcome to the Currency War: Russia, China, India Bypass the Petrodollar,” by John Rubino, who manages www.Dollarcollapse.com and writes for CFA Magazine, on March 26, 2014. Rufino says:
Russia is aggressively cementing the next, biggest (certainly in terms of population and natural resources), and most important New Normal geopolitical Eurasian axis: China – Russia – India…. If Russia, China and India decide to start trading oil in their own currencies—or, as Zero Hedge speculates, in gold—then the petrodollar becomes just one of several major currencies. Central banks and trading firms that now hold 60% of their reserves in dollar-denominated bonds would have to rebalance by converting dollars to those other currencies. Trillions of dollars would be dumped on the global market in a very short time, which would lower the dollar’s foreign exchange value in a disruptive rather than advantageous way, raise domestic U.S. interest rates and make it vastly harder for the U.S. to bully the rest of the world economically or militarily.
The article continues:
For Russia, China, and India, this looks like a win/win. Their own currencies gain prestige, giving their governments more political and military muscle. The U.S., their nemesis in the Great Game, is diminished. And the gold and silver they’ve vacuumed up in recent years rise in value more than enough to offset their depreciating Treasury bonds.
A similar theme was written about in the article “This Is Horrifying for the West & Will Bring the U.S. to Its Knees” by John Embry, chief investment strategist at Sprott Asset Management LP, and King World News:
The move by major nations to price oil in other currencies is huge. These other nations are sick and tired of the advantage the United States has enjoyed. This is why there is a move to start pricing international transactions in a currency other than U.S. dollars. This could be the thing that brings the U.S. dollar to its knees…. I think the petrodollar movement could certainly trigger something like that.
A similar theme on currency trends was voiced in an article titled “Has the Stock Market S&P Topped at Exactly the Same Price as Gold?” www.marketoracle.co.uk/Article45345.html, dated April 25, 2014:
On the other hand, of higher importance in our view, is the cracking dollar reserve currency. It is widely accepted that the U.S. has enjoyed an exceptional privilege having a world reserve currency. The U.S. has been able to grow its debt mountain to a level never seen before in the history of mankind because it had a universally accepted currency which was used in the most traded asset classes, in particular oil (the petrodollar). However, the end of the dollar reserve currency seems to be imminent. Based on historical standards, world reserve currencies have lived on average 27 years. Note that the current dollar hegemony is ongoing for 43 years. Prior threats to the petrodollar have been laughed away by the use of military force. The Ukrainian case, however, has the potential to become a pivot point. Clumsy sanctions against Russia by the West point to retaliation right to the core of the monetary system: the petrodollar. Russia is about to sign energy contracts with its major trading partners in non-dollar currencies. We believe this will act as a precedent, and several Asian and emerging countries will follow. It will result in a loss of trust in dollar denominated assets, undoubtedly affecting U.S. equities. Needless to say, this should also be a major catalyst for precious metals.
If a company has currency exposure that is unhedged, and a crisis event occurs, the company may be forced to report a significant foreign exchange loss. Emerging market companies are known for being contagious. That is, when one sneezes, they all catch a cold. Emerging market equity and debt markets do not have the immunity to extreme volatility that developed (domestic) markets enjoy. This immunity is due in part to the U.S. reserve currency status that causes global investors to perceive the U.S. as a safe haven in times of crisis. However, the U.S. reserve currency status is likely to be challenged in the future, which will pose a problem to the capital markets (and appraisers) who look for risk-free benchmarks in their discount rate-setting quantitative models. Degradation in the U.S. dollar status will likely coincide with a sell-off of U.S. Treasury securities that have been a risk-free standard for the investing community for decades.
Sector. This area of due diligence examines the industry or sector in which the company operates. It may also involve a regional trade group, such as NAFTA or Eurozone. Some industries are inherently local, such as grocery stores, where the primary economy is the local economy. On the other hand, for a company in the petrochemical industry or technology industry, the focus would be on regional, or possibly global, economic forces.
An exception to this rule is natural resource companies, where the location of the resources is a critical element in assessing country and political risk. According to Marin Katusa, chief energy investment strategist, Casey Research, “the risks we face in the world of resource investing, though, are some of the most unpredictable out there. Resource companies navigate risks running from commodity price swings to taxation changes, from geologic uncertainties to the challenges of new technologies, from floods and tornadoes to labor unrest.” (See www.caseyresearch.com/cdd/never-underestimate-country-risk.)
Recap. If you go through this framework to conduct your due diligence, you may find that the MNC is not as risky as you thought. A full risk penalty associated with where the company is headquartered (the sovereign risk of that country) may have to be adjusted given the results of your analysis of the four areas of the CCCS framework. Of course, it could go the other way. The analysis can uncover more risk in a company that, even though headquartered in the U.S., exports products offshore to emerging markets and has plants offshore in developing nations.
Think of a company on a “risk-return spectrum.” At one extreme are those low-beta, stable companies domiciled in developed markets. At the other extreme are companies located in and totally dependent on a very risky local economy, such as Afghanistan, Syria, Sudan, or Zimbabwe. Between these two extremes are many companies that deserve some, but not all, elements of incremental risk premium attributed to country/political risk.
The CCCS methodology can help the valuation analyst select an appropriate cost of equity model so that the risk rate ultimately makes sense in view of the company’s characteristics, including industry sector and flow of currencies throughout its worldwide operation. The potential risk adjustment to the cost of debt in the WACC development is discussed later in this article.
CCCS case study. To illustrate the CCCS framework, let’s consider an example of an MNC with U.S. headquarters that uses an assembly plant (called a maquiladora) run by the U.S. entity in Mexico. The assignment is to develop a cost of equity for the plant operation in Mexico.
A traditional Mexico operation that is mostly dependent on the local economy is regarded as more risky than a U.S. operation. For example, the latest Morningstar data (2013) put a cost of equity (CRRM linear model) for Mexico of 16.79% versus a cost of equity for the U.S. of 10.92%, or a difference of about 587 basis points of total increment required return. A Mexican operation that is completely dependent on the local economy may warrant the full Mexican country risk penalty, such as the difference observed in the CRRM linear model.
Looking at our subject operation, because the plant’s parent company is in the U.S., it may be dependent on the U.S. economy or global marketplace. If that’s the case, you can expect that the cost of equity is lower than what you would estimate for a strictly Mexico-based operation. Further due diligence bears this out. The plant sells 100% of its product to its parent, which is an MNC with strong global brand, technology, and customer base. The plant receives U.S. dollars for its sales. Therefore, this operation cannot be compared to a strictly local operation.
The notion that our subject operation is less risky than a stand-alone business in Mexico (solely dependent on the local economy) is part of the “integrated versus segmented” theme talked about by academia and finance professionals in the context of country risk assessment. There are arguments to be made that in recent years the Mexican and the U.S. economies have become more integrated due to the growing trade openness among them, particularly after the implementation of the NAFTA.
In our subject operation, the country risk is mitigated because the plant is part of a global operation and not dependent on the local economy. The currency risk is mitigated, as well, because its sales are transacted with a more attractive, harder currency than Mexican pesos. How do you quantify this mitigation of risk? You may want to consider Professor Harvey’s view that currency risk can be 50% of total incremental risk. You could argue there is still the residual country risk that is associated with terror, violence, and corruption that is characteristic of an emerging market such as Mexico. A cost of equity that is bracketed in at the lower end of the spectrum by the country spread model (10.38% cost of equity), which typically bakes in minimal currency risk, and international CAPM model (11.82%) would be worth considering so as not to underestimate value by using too high a risk adjustment.
There appears to be ample evidence that the appropriate cost of capital for our subject operation would justify a lower cost of equity than a model that uses the full amount of Mexican country sovereign risk, such as the CRRM model (see Claude B. Erb, Campbell R. Harvey, and Tadas E. Viskanta, “Expected Returns and Volatility in 135 Countries,” Feb. 7, 1996).
The substantially lower currency risk of the plant implies an adjustment of possibly one-half of the total incremental risk of 587 basis points (U.S. versus Mexican CRRM). Such an adjustment would lower the CRRM required rate of Mexico 13.86% (halfway between Mexico at 16.79% versus U.S. at 10.92%). Because the subject business derives its sales from U.S.-based customers, there is an argument that the country risk adjustment could be even lower, with the apparent floor being above the CRRM linear rate for the U.S. This is because the operation is located in Mexico and could be negatively affected from certain country factors.
A two-thirds reduction of the incremental risk shown by the CRRM model of 587 basis points to reflect the reduced risks of this Mexican operation as explained above would put the cost of equity at about 12.86%.
Developing the WACC. In the context of assessing country risk, a rather subtle refinement needs to be made to the applicable cost of debt that is included in the overall WACC model.
In a nutshell, the question of whether to adjust the cost of debt for incremental country risk depends on the specific facts and circumstances. For example, let’s say our subject entity is an MNC with a mix of offshore operations in locations ranging from developed countries to emerging countries. Let’s also assume that the MNC has significant securitizable assets held in developed countries. In this case, there may be an argument that any material debt funding could be done in such developed countries at rates that do not have any material country risk.
On the other hand, the appraiser may conclude that the subject entity is segmented and deserves the full country risk/sovereign risk penalty. If the appraiser wants to adjust both the cost of equity and the cost of debt for such incremental risk, he or she should review the works of Damodaran.
For example, go to Damodaran’s website, pages.stern.nyu.edu/~adamodar/pc/datasets/, and, in particular, this file: ValuedataJan2014.xls (see Exhibit 2). You see that the assumed equity risk premium (ERP) for the U.S. (mature) is 5%. The global equity risk premium, which takes into account a portfolio of countries, many of which are emerging or developing in nature, is 6.35%.
The difference between the U.S. and global ERP is 1.35%. This is not the amount in theory you would add to adjust the cost of debt for country risk for such a global portfolio. In his past writings and speeches, Damodaran has indicated that, in general, emerging market debt is less volatile than emerging market equity. “You can estimate an adjusted country risk premium by multiplying the default spread by the relative equity market volatility for that market (Standard deviation in country equity market/Standard deviation in country bond),” says Damodaran. “I have used the emerging market average of 1.5 (equity markets are about 1.5 times more volatile than bond markets) to estimate country risk premium.” (See pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html.)
Using his global default spread (to add to the cost of debt) of 0.90%, the suggestion is that, while equities are adjusted upward for perceived global market risk by 135 basis points, debt is adjusted upward by 90 basis points. The ratio of 135/90 is 1.5 and is consistent with Damodaran’s earlier comments.
Other data suggest this theme. Damodaran has analyzed relative volatilities of equity versus debt markets in a variety of emerging market countries and found that “for emerging markets, equity is between 1.5 and 2.0 times more risky than bonds.” This suggests that for developed markets the ratio is 2.0. Dimson, Marsh, and Staunton corroborate this in their text Triumph of the Optimists, which states: “For the United States, which ranked toward the lower end of the country risk premium spectrum, we find that the standard deviation of real returns on stocks was 20.2% compared with 10.0% for bonds.” You can review relative volatilities of various stock and debt markets using Bloomberg, for instance.
In summary, whatever models you run or use to quantify the incremental cost of equity adjustment for a particular country or portfolio of countries, typically the adjustment to debt is different but can be reconciled using the base work of Damodaran as a guide. In fact, he uses debt-versus-equity volatility data to estimate equity returns from debt market returns.
Considering a large portfolio of countries. My experience has been that an MNC is often involved in dozens of countries and the goal is to value the aggregate firm. To address country risk analysis in an efficient manner, I conduct CCCSrelated due diligence to learn how dependent the overall business and each affiliated country is to global trends versus local economic and political conditions.
For instance, if the business is tied to the energy industry or to certain technology that is viewed as a global commodity, then the local country conditions are less relevant but still worthy of consideration. This may be the case where the country spread model has special merit, as the inputs to this model naturally result in a lower cost of equity that may be more appropriate than a full country risk penalty that results from the CRRM model. On the other hand, if this is not a global industry, but rather more dependent on the local economies, then the fully risk-priced CRRM model may be best as a proxy for the country risk adjustment. The analyst may consider both country spread and CRRM models to bracket in full risk and a reduction in risk in terms of cost of equity estimates.
To manage the quantitative analysis of dozens of countries, I often obtain a representative sample of the largest-end markets (e.g., those countries that generate the highest sales and EBITDA) and then weight the specific cost of equity estimates for the models I think are best proxies for the nature of the risk. In other words, CCCS due diligence may suggest the firm is quite dependent on the local economy, or it could suggest the firm has less risk due to the industry in which it operates, the currencies it receives, and the existence of global branding and technology.
At that point, the analyst can develop a weighted average risk analysis that appreciates the significant countries that contribute to overall country risk. By doing so, one is consistent with the view of Damodaran: “When valuing emerging market companies, analysts pay too much attention to where a company is incorporated and too little to where it does business.” It has been my practice to review the risk of an MNC’s end markets and incorporate this into the discount rate. If there were significant production facilities in any country but no sales, this also would be considered.
An example extracted from Excel is shown as Exhibit 3. In this example, we view each country’s business to be mostly dependent on the local economy. We applied a CRRM model to benchmark risk of each contributing country to the U.S. (Note that sales are for illustration only and CRRM is per a recent Morningstar International Cost of Capital report.) This type of analysis suggests a U.S.-based cost of equity could be adjusted upward by about 2.3%.
Final thoughts. Developing discount rates for an international valuation project in today’s world entails more than using computer/calculation models to build a base-weighted average cost of capital. The dynamic nature of the global economy is such that the valuation analyst must not only be vigilant but willing to break out of the models to uncover what really is impacting the subject company. The CCCS framework is designed to guide your due diligence in the vital areas of company, country, currency, and sector.
1 Stock indexes used in this analysis (Exhibit 1): Australia: S&P/ASX 200 Net Total Return Index; Canada: S&P/TSX Composite Total Return Index; Switzerland: Swiss Market Gross Total Return Index; Eurozone: Euro Stoxx 50 Total Return Index; U.K.: FTSE 100 Total Return Index; Japan: Nikkei 225 Total Return Index; Norway: Oslo Stock Exchange OBX Index (It has been a total return index since April 2006); New Zealand: NZX 50 Total Return Index; Sweden: OMX Stockholm 30 Total Return Index; Singapore: FTSE STI Total Return Index. All stock market indexes are in local currency terms, and all include reinvested dividends.