I set out to identify what could be factors affecting investors in the developed world to undervalue emerging market companies due to undue risk aversion in emerging markets which is often reflected by rather arbitrary and often exaggerated country risk premiums. The studies undertaken have confirmed my view that practitioners and probably especially small to medium sized companies such as many of the Danish niche companies, do exaggerate the risk which should be applied to a DCF-valuation of a company in an emerging market, especially when we are considering companies in the most developed emerging markets such as the BRIC-countries.
There are obviously many reasons to be extra prudent in emerging markets and disregarding the valuation of a company, some markets may be found, rightly so, by decision makers to be so unattractive due to political instability, civil war, etc. that it is preferred to avoid any investments in such countries despite the potential value creation possible if local companies can be acquired at bargains prices.
45
Generally the imperfections characterizing emerging markets are, however, less dramatic and relate to matters of financial intransparency, uncertain legal systems, information asymmetry and agency cost and “excuses” used often to apply a very high risk premium is the fact that the emerging markets are unpredictable, i.e. statistically more volatile. An important point in this respect is, however, that such volatility has the benefit of being relatively uncorrelated to the developed markets.
The most fundamental blow to the conservative valuation approach is seen if you consider:
(i) yourself (or your shareholders) to be globally diversified;
(ii) the relevant emerging market to be an integrated part of the global financial market;
and
(iii) the special country specific risk factors affecting the company to be un-correlated with the global market
Based on these three assumptions, you would be able to (/have to) approach a valuation of a company in an emerging market with the same aggressiveness in respect to WACC that you do when valuing a company in Europe or the US. The SML would thus be the global SML and CAPM-input to the WACC-calculation would be identical to a European valuation. The volatility of the market and company performance would be discarded as “irrelevant”
unsystematic risk and the political risk etc. associated with the country in which the target operates will also be discharged as a diversifiable risk, not justifying a country risk premium.
This may seem very aggressive considering recent experiences in the financial crisis where even developed markets (or actually especially developed markets) have been suffering from extreme volatility and risk. You also still regularly have political unrest in even relatively developed emerging markets such as Thailand. You do, however, need to keep strategic concerns of entering emerging markets aside from the technical valuation of companies in emerging markets. This is also why I conclude that it is advisable to appreciate the truth of applying an international WACC, and instead focus on capturing concerns related to the investment when building scenarios of the financial forecast.
It is also important to realize that a lot of the challenges associated with making acquisitions in emerging markets are rather execution and integration challenges rather than commercial
46
and technical challenges impacting the valuation of the company on a standalone basis. This does, however, not mean that an investor should not be extra cautious when approaching the acquisition opportunity:
The due diligence typically needs to be particularly thorough in order to build a proper comfort that the business is built on sound business practices and with full disclosure of the financials relevant to the DCF.
The relevant market in the relevant country should be analyzed in detail to understand special challenges in the emerging market as compared to Western markets within the same business area.
The negotiation process should be approached with a special attention to cultural issues and the “abuse” of cultural etiquette.
The post merger-integration should be considered a key challenge, which should already be prepared and analyzed for potential targets relatively early in the process.
Even if you take care addressing all these challenges with the utmost diligence, it is quite certain that it will be more difficult to predict the future success of the acquisition than it would if you were acquiring a company in your home country or in another developed market.
The question is, however, what risks are most likely to impact the value of the business materially. The risk of value destruction due to cultural challenges and related integration challenges will thus often be more notable risks than the risk of nationalization which is often a topic of discussion when considering country risk premiums in emerging markets.
My overarching conclusion is thus to avoid applying arbitrary country risk premiums to valuations based on very crude assumptions about emerging market risk in general or the country risk profile of the country at large (typically based on the sovereign debt spread).
Instead, the risk associated with emerging market acquisitions should be approached by ensuring very thorough work building scenarios for the financial performance of the target after an acquisition, as will be discussed in more detail in Section 4.2.
Although I find it theoretically and conceptually correct to avoid operating with a country risk premium, it may at times be relevant to use such an instrument to take into account specific
47
relevant risk factors of the company being acquired. As I will revert to in Section 4.3 such an ad hoc risk premium should, however, always be carefully tailored to the individual company being acquired and not only based on the risk profile of the country in which the company is headquartered.
4.2 Using Scenarios as an Alternative to a More Arbitrary Risk Premiums