The realm of business valuation extends beyond the scope of valuing a domestic (i.e., U.S.) business to placing a value on an entity that is multinational (“MNC”). Participating in valuations that involve offshore markets can be particularly challenging. These assignments can involve, for instance, valuing a technology company in Singapore, a chemical plant in Saudi Arabia, a textile manufacturer in China, or an auto parts maquiladora in Mexico–along with the need to measure and justify a discount rate for each business.
This article discusses several key considerations pertinent to the valuation of an MNC, with particular focus on the development of a discount rate/cost of equity. Subjects reviewed include:
- Key business valuation drivers.
- A due diligence framework to use in the review of MNCs.
- Related academic and investment professional views.
- Typical cost of equity models to consider.
- Relevant research studies.
Also provided is an example of how to evaluate a business in a country that has been the subject of recent headlines: Greece.
Growth, Risk, and Profitability
A key theme in business valuation is recognizing the importance of the three pillars (i.e., value drivers), which are growth, risk, and profitability (GRP). When using a market approach for instance, and developing arguments for selection of particular market multiple measures such as market price of invested capital (MVIC) to earnings before interest, taxes, depreciation, and amortization (EBITDA) or MVIC to revenue multiples, the GRP framework is critical to providing quantitative and qualitative support to the multiple selection.
When employing an income approach, the elements of GRP are at work. Superior sales and earnings growth at normal risk will drive a higher value than a scenario that has lower growth and margins and higher risk. A company that can generate attractive EBITDA margins (superior to their peer group) and offer superior growth (at a risk level that is perceived to be no more risky than its peers) is likely to be valued at a superior MVIC to EBITDA multiple than its peers. Furthermore, such an entity, observed to have superior EBITDA margins, higher growth, and average risk, will likely sell at an MVIC to revenue multiple in excess of its peers.
For instance, the circumstances could be that the subject company has superior technology that permits it to earn margins that are three times better than the peer group. All things equal, this firm may sell at three times the MVIC to revenue multiple of its peers. If the company is part of an MNC that distributes leading technology to its offshore affiliates, as well as part of a global industry, when valuing a subsidiary in an emerging market, the risk nature of the business is influenced by the industry it is in. The tech firm benefits from leading technology and being in a global sector. The tech firm discount rate would likely be lower than if it were a grocery store in the same country. In this example, the grocery store does not benefit from leading technology nor participate in global supply and demand. The grocery store is highly correlated to the country it is in, whereas the technology firm is more correlated to its sector than to its location.
Due Diligence Framework
When valuing an MNC, one should expand the due diligence process to include areas of questioning that solicit information about what countries are part of the company’s business environment, and also review studies on country risk and return and country risk ratings. A due diligence framework the author has pioneered is companycountry-currency-sector ( CCCS).
Country. Ultimately, the value of an MNC should consider GRP and CCCS. The risk analysis done will include consideration of what countries the subject company sells to. The astute views of Professor Damodaran of New York University and investment manager Gary Brinson are relevant to this discussion. In effect, what these experts have suggested is that the location of a headquarters or where the company’s publicly traded stock is exchanged is not nearly as important, if it matters at all, as where the company generates its sales.[i] The consultant may want to reference the Morningstar/Ibbotson International Cost of Capital report, the Institutional Investor periodical, and Political Risk Services’ country reports to get critical information on individual country risk and cost of equity models.
Currency. When we speak about risk we are talking about total risk and, equivalently, what would be an estimated total return that a willing buyer (as per IRS fair market value definition) or average market participant (Financial Accounting Standards Board) would judge applicable. Total return includes the elements of yield plus capital gain. Inherent in total return is an understanding of what currencies are involved. When investing in non-domestic businesses, the MNC is exposed to other currencies, and currency risk is a significant component of total risk. Similarly, currency volatility can contribute to or detract from 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.
The company may have operations located in a developing market that will likely involve exposure to local country currency volatility. Or, it could have sales that generate hard forms of currency in currencies viewed as safe havens. The point is that currency is a major contributor to risk, and if the subject MNC is by its nature gathering some form of safe hard currency in its various offshore affiliates, the perception of country risk is mitigated to some extent compared to a company that is completely exposed to individual local country currencies which are from emerging markets.
The world reserve currency status afforded to the U.S. is a cherished position. It translates into trade being denominated in dollars and the demand for dollars is heightened from this. A shift away from the U.S. dollar as a reserve currency would likely spell chaos in the markets. The impact of such event could be a steep drop in the dollar, and rising interest rates and required returns for domestic investments. If a company has unhedged currency exposure, and a crisis event occurs, the company may be forced to report a significant foreign exchange loss. Emerging market companies are known for contagion (when one sneezes they all catch a cold). Emerging market equity and debt markets suffer from the extreme volatility that domestic markets are sheltered from, partly as a result of the U.S. reserve currency status, as global investors perceive the U.S. as a safe haven in times of crisis.
It is recognized that in today’s environment characterized by governments printing fiat currency to stimulate economic growth and to achieve political agendas, and with talk of the potential breakup of the European Union, belief in the resiliency of hard currencies may be ill-advised. China is said to be hoarding gold in anticipation of its yuan becoming eventually the next world reserve currency.
Nonetheless, as long as investors flock to U.S. Treasury securities as a safe haven, the dollar will remain in its apparent cherished position. At some time in the not too distant future a paradigm shift could displace the current economic leaders with new players, such as one or more BRIC nations, or a mix of currencies and commodities may comprise a new world currency. Once the shift occurs, investments in precious metals may be favored, along with currencies issued by countries rich in natural resources, having fiscal discipline, low corruption, and low debt to GDP ratios. In fact, the rise in the price of gold since 2001 coincides with the slow but gradual process of fiat currency devaluation. However, until the capital markets make such decisions, currencies from strong, developed countries are viewed as superior to those of emerging markets.
A couple of recent headlines illustrate the trend:
- “The Supremacy Of The US Dollar Is Behind Us.”[ii]
- “Bries’ Move to Unseat US Dollar as Trade Currency.”[iii]
The purchasing power erosion of the U.S. dollar demonstrates currency risk. The dollar lost 95% of its value from 1913 (inception of the Federal Reserve) to 2010. The dollar is still the world reserve currency used as the petrodollar but apparently some nations seek to replace the dollar with a new surrogate. Trends indicate a shift out of the dollar by world central banks, with Asia taking a key role in its purchases of gold and China liquidating U.S. Treasury securities.
Essentially, gold is the proverbial “canary in the coal mine” and a hedge against loss of purchasing power resulting from over-printing of fiat currency and mountains of debt. In the 1970s gold went from $35 to $850 per ounce. The same trend in gold prices, which are recognized to have bottomed in roughly 2001 at a price of around $250 an ounce, implies gold could reach $6,000 or more in the next few years as the full impact of fiscal and monetary irresponsibility comes home. Gradually, investors are coming to realize that in such turbulent times, gold is a vital asset for a portfolio. The International Monetary Fund recently said that the IMF recognizes gold as an option for investors seeking portfolio protection.[iv]
Gold and other precious metals may be the final safe haven as the world economy implodes under the pressure of fiat and derivatives. Nations have recently started to acquire gold and will continue to seek gold for their reserves. In fact, discussions abound as to whether countries will confiscate gold again as their desperation increases. The nationalization of gold mines is a perfect example of country risk. Actions by countries to renegotiate contracts for a larger share of mining profits are forms of country risk, as would be military coups and labor unrest. Political risk insurance is a must for companies such as mining and exploration firms.
The key point is that currency risk has been and will continue to be a major contributor of risk. A major change in what is considered the world reserve currency could have an overwhelming impact on the capital markets, threatening economic stability for some time. This is viewed as a systemic risk, and it will be hard to find shelter from such an economic event. By definition, systemic risk is not diversifiable. Another point is that we may experience in the not too distant future a shift where safe havens of old, such as the U.S. dollar and related Treasury securities, are discarded in favor of a new paradigm. Valuators will need to monitor capital markets and judge if adjustments are warranted to remove abnormal market behavior from valuation metrics.
Sector. Related to the question of where a company generates its sales is the theme of what industry, or sector the firm participates in. Some industries are inherently local, such as grocery stores, where the local economy is the primary economy to study. In contrast, for a company in the technology industry, the supply and demand for products is likely based on regional or even global economic forces; therefore, study of the local economy is less relevant.
An exception to this relates to natural resource companies, where location of the resources is a critical element in assessing country/political risk.
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.[v]
A sector-based risk analysis still must consider that all countries are not equal in terms of corruption, risk of nationalization, and other political risks. In fact, some people today are taking the view that risk of nationalization needs to be considered with both emerging and developed countries, especially when one deals with the mining sector.
Benefit of Due Diligence. Thus, conducting due diligence along the lines of company, country, currency, and sector has its benefits in creating a better profile of an MNC and weighing the risk penalty that is associated with where it is headquartered or conducts business. A company can be thought of as on a risk-return spectrum, from those low beta, stable companies domiciled in developed markets to the extreme situations of companies located in and totally dependent on a local economy such as Iraq, Iran, Syria, or Sudan for instance. In between these two extremes lies many a company that deserves some elements of incremental risk premium.
CCCS can help the valuator 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.
Cost of Equity Models
Recognizing that the risk of a firm can vary depending on how diverse the company is, where its end markets are, and how correlated its mix of business operations are, we next explore several cost of equity models and discuss their respective merits.
Selection of models has been written about by this author.[vi] The theme is that each cost of equity model has its own bias. Harvey’s country risk rating model (CRRM) is a pure country risk indicator, measuring total risk of a particular country.[vii] The country spread model, by design, provides less than a full measure of total risk as its inputs include debt markets denominated in non-local currencies. This method provides a cost of equity indicator that may best match a situation where the business participates in a global sector rather than being influenced from local economic factors only. The international capital asset pricing model (ICAPM) is also worthwhile considering, as it attempts to capture the risk diversification benefits of a particular country’s potential lower correlation to the world market.
As discussed below, the more a country correlates to the world market, the less possible risk diversification benefits can be realized by adding this country to the investment mix, whether it is an investment portfolio or a multinational company deciding on where to expand. Finally, the relative standard deviation model is useful to review to see how market extremes (euphorias and panics) spread like wild fire within the emerging markets, especially to adjacent areas, and a sell-off in one country can trigger an echo wave in other countries even if there is no reason other than risk aversion on a global scale. The relative standard deviation model, by nature, takes spot market data, which is often subject to extremes, and prices a cost of equity using such spot data.
For those versed in cost of equity models, with their spectrum from low to high, country spread and ICAPM provide medium to lower risk models; CRRM and relative standard deviation provide high-end indicators of risk. An analogy exists in the option model venue, where the Black-Scholes model provides a relatively lower estimate for an option, while the Longstaff model provides the upper bound in option values, and the Finnerty average/Asian put model generally provides a medium level indicator of option value (as volatility increases). Seasoned practitioners will select the model (or weight it higher than other models) that best fits the situation rather than using all models equally weighted (for application to either the cost of equity or options). This author has encouraged the valuator to get their head out of the model and do their due diligence first, and only select a cost of equity model for measuring country risk after gaining better appreciation for the nature of the firm in terms of due diligence based on CCCS.
When the analysis of a risk rate is completed, it can then be used to make any appropriate adjustments to market multiples used to account for any perceived incremental risk associated with the subject company versus the peer groups. If your comparable companies are MNCs which also are exposed to a broad diversity of countries, the comps may already factor in this risk via capital markets pricing. Issues with respect to valuing an MNC also include whether the MNC is in one sector or a conglomerate. The analyst may want to do a consolidated valuation as well as segment values, to consider the breakup value of the firm.
In addition to selecting an appropriate cost of equity model, the analyst should also consider that the cost of debt component in the weighted average of capital (WACC) model may require a risk adjustment. Studies show that in general, equity is more volatile than debt and, therefore, any risk premium judged applicable to a cost of equity would need to be adjusted to develop a consistent cost of debt adjustment. Developed countries typically have equity volatility at two times debt, whereas emerging countries will have ratios of 1.5 to 1.75. For those truly dangerous countries, like Iraq, debt may be just as risky as equity and a 1: 1 ratio may apply.
Support for Portfolio Analysis
The above theme of assessing risk based on a worldview of the business begs mention of statistical concepts of correlation and variance. It also reminds us that companies today are being managed more like a global investment portfolio, where investments are taken in emerging markets to gain added growth potential and risk levels that are believed to be diversified, at least in part, through the mix of countries a, MNC invests in. With diversification, there are associated benefits of lower correlation and variance between emerging markets and developed nations.
The grandfather of modern portfolio theory, Harry Markowitz[viii] offered to the investment profession an awareness of portfolio management that is pertinent today. Key themes associated with Markowitz include consideration of variance and co-variance of investments and the recognition of the benefits of negative or low correlations in risk reduction and return enhancement. Markowitz’s observation about asset allocation, “It’s not the variance you have to worry about, it’s the covariance:’ sums it up.[ix]
The relevance for valuators includes asking questions in due diligence to learn from a country risk point of view where the subject company is exposed, and if the risk exposure is focused on one country or multiple. The analyst should obtain a detail of sales by country and develop a weighted view using sales or EBITDA, for instance, to gauge the relative risk exposure the firm faces with their mix of end markets. This is consistent with the lambda approach espoused by Professor Damodaran, which provides a tool to weigh a business’ risk exposure to various end markets.[x]
In addition, the analyst would want to ask whether the mix of countries is highly correlated with each other. A business exporting to primarily developed countries would arguably be exposed to the mix of such countries’ political and economic risks, which in this global marketplace, as evolved over the past few decades, are likely highly correlated with each other–thus providing no material risk diversification. Adding emerging countries to the mix of export markets may offer some risk diversification, in that such end markets may not be as correlated to the world market as well as developed nations. An MNC may have a sufficient mix of end markets in emerging nations so that some of the risk of such developed countries is diversifiable at the portfolio level.
Investment manager Gary Brinson has contributed greatly to the investment profession and our understanding of how experts perceive MNC risk. He has been credited with developing the field of international investing by questioning the conventional wisdom that such investing was too risky.[xi] Brinson’s views on focusing on sector rather than country, and on where revenues are generated, are key themes that valuators can learn from. MNCs are often sector focused and often derive a significant portion of their revenues from a variety of offshore countries. Brinson’s view that the country level should not be the focus is illustrated in his statements such as the following:
More than 70 percent of world equity market capitalization is made up of companies conducting their business on a multinational platform…. The real issues are where the companies derive their revenues and incur their expenses across the globe and who their competitors are in the global markets. Any thoughtful analyst would be hard-pressed to name an industry in which global competition is absent. Thus, for an investment portfolio, sectors and industries will become the main building blocks of equity exposure. I do not mean to say that geography is not important to all companies. It may be particularly important for some–in small emerging markets, for example. Or if you are invested in a chain of hot dog stands located only in southern California, the geography and climate of southern California matter. For the large multinational companies, however, country is irrelevant. …Does the country in which these multinational companies are headquartered matter? It matters about as much as Microsoft Corporation, for example, being headquartered in the State of Washington.[xii]
Finally, as mentioned earlier, Professor Harvey has developed a robust cost of equity estimating tool, the country risk rating model (CRRM). Harvey’s CRRM provides a rare empirical reference that considers capital market data since 1980, correlated via a regression to the country credit ratings provided in Institutional Investors. Harvey’s original modeling used 47 countries and associated credit ratings that covered more than 100 countries. Using the regression model, where return is the dependent variable and country ratings an independent variable, Harvey was able to interpolate estimated equity returns for all those countries that did not have capital market data.[xiii] Thus the CRRM captures a risk-return spectrum of over 30 years involving capital markets and country rankings. To this author, there is no more robust study on the planet. But one should recognize that the CRRM model fully prices in country risk, and some companies do not deserve the full sovereign risk penalty.
Currency Risk Contribution. Another vital point involves the importance of currency risk in terms of its contribution to the total risk of the company. In prior articles, the present author has referenced research of Harvey, others, and myself to demonstrate that currency risk can represent half of incremental country risk.[xiv] For example, if the cost of equity for a U.S. company is 11 %, and for a company in Russia it is 18%, a large part of the incremental risk may be attributed to currency risk. Due diligence may reveal that a subject company operating in Russia participates in a global sector and exports of its output yield hard currency of other developed countries, providing a natural hedge against the risk of being exposed entirely to rubles. The applicable discount rate (cost of equity) model may be the country spread method which inherently does not consider all aspects of total risk, as this business is not as exposed to local risks (including local economy) as another company that sells its goods and services solely within Russia.
Impact of a Financial Crisis
In panics, it is a challenge for the valuator to understand what the new norm will be once the panic subsides, and use of spot market data on government bond yields, for instance, may not characterize the risk of a particular company within a country in crisis. For example, is Greece going to collapse? Yields on Greek debt have risen to levels that make one wonder about its future. Yields on Greek debt have risen approximately 3,000 basis points (bp) or more above levels of just a couple of years ago.[xv] Does that mean a business in Greece suddenly deserves an increase in their cost of equity of 30% (3,000 bp)? This author thinks not, as discussed below.
Example from European Debt Crisis. The recent crisis in Europe raises the question about what to consider if studying a country such as Greece. The crisis in Greece came up fairly quickly. Exhibit 1 is an extract from the Institutional Investor September 2011 Country Credit Rating. It shows that between March 2011 and September 2011, Greece’s rating fell significantly, from 78 to 131 (where a rating of 1 is lowest risk, and was assigned to Norway in both ratings).
Presented in Exhibit 2 is an extract from the International Cost of Capital Report (Morningstar/Ibbotson, 2011) which comes out once a year and relies on Institutional Investor for the March ratings. For most of 2011, the data was not appropriate for Greece, as its situation had deteriorated materially. How to handle this? One way is to use comparable countries and identify which countries Greece’s September 2011 rating resembled most.
News reports may give the impression that Greece will terminate as a country, as its leverage is so hard to handle. However, using the comparable country analysis, one can form a reasoned view of where experts, as measured by Institutional Investor’s ratings view Greece’s risk.
As referenced in Exhibit 1, Greece’s rating of 131 put it in the neighborhood of countries such as Niger, Rwanda, and Swaziland. One can then cross-reference to the Morningstar/Ibbotson International Cost of Capital report in Exhibit 2 and observe that the cost of equity (CRRM) for countries such as Swaziland was estimated at 31 % to 29%. This compares to the CRRM for Greece of 23%-24%, or an implied increase for Greece as of September 2011 of as much as 800 basis points (31.10 – 23.01).
The consultant would still want to explore a CCCS due diligence to learn more about the particular Greek company and find whether the company deserves the full stigma of Greece’s risk penalty. This analysis is surely different from simply applying an observed yield spike (levels of 3,000 bp) and adding that to a cost of equity as a proxy for what Greece’s cost of equity should be as this crisis unfolds.
The use of a comparable country analysis is one to keep in your tool kit. For instance, in doing a retrospective valuation of a Singapore firm, the present author found that at the retrospective value date, Singapore did not have capital market data. Therefore, fixed income spreads or stock market data for Singapore was unavailable to begin to bracket in how much riskier Singapore was compared to the U.S. However the present author then found (from Political Risk Services) ratings of Singapore and other countries with similar ratings. It was possible to identify other countries that did have capital markets at that time, and were of similar country risk, as a means of measuring what investors would likely demand in terms of a risk premium for investing in Singapore.
Valuation of an MNC presents challenges that do not exist with domestic firms. It is important to identify where the strategic planning and global risk management functions of today’s multinational firms are similar to investment portfolio management. The takeaway for valuators: MNCs are behaving in the spirit of a board of directors with fiduciary responsibility to maximize shareholder value. By acting more like investment committees allocating capital to achieve best return for risk; MNCs are practicing modern portfolio theory (MPT) to some degree. A related trend is that market participants (MPs) are often MNCs. MPs may be able to enjoy unsystematic risk (diversifiable risk) including some country risk diversification (diversifiable political risk). Therefore MNCs, which typically portray a real-world MP, achieve enhanced returns at less risk. They prove that diversification internationally is better than purely domestic diversification.
When conducting due diligence on an MNC valuation experts should ask how management perceives country risk and what risk diversification benefits they see. Ask about activities the firm does to hedge risk as well as whether any natural hedges exist from the flow of currencies in their worldwide operation or from participating in a global sector. A natural currency hedge, for instance, from the multiple currencies a firm receives from sales, would be a hedge to consider when judging if a particular company (which exports heavily to developed countries) deserves the full penalty of being headquartered in a developing country. The treasury and risk management departments of many MNCs may be a place to gain perspective on how the firm sees country risk exposure.
Finally, when working with an MNC that has invested in numerous foreign affiliates, it is wise to conduct due diligence before selecting a particular cost of capital model, such as CRRM, country spread, or ICAPM. A due diligence framework that covers the topic of company, country, currency, and sector can generate important perspectives about a company. It may suggest the risk associated with the firm is influenced by diversifying aspects of being part of a global or regional industry, where the influence of local country politics are less relevant to the business, and by a firm’s operations involving multiple currencies, which can provide a form of risk diversification. A valuator is wise to learn what percent of sales are generated in each respective country and develop a currency weighted risk analysis using Harvey’s CRRM to provide a more reasoned view of what risks impact a particular company.
[i] See, e.g., Damodaran, The Dark Side of Valuation: Valuing Young, Distressed and Complex Businesses, 2nd ed. (FT Press, 2010).
[ii] Sinclair, Investment Watch, 3/26/12, http://investmentwatchblog.com/jim-sinclair-the-supremacy-of-the-us-dollar-is-behind-us/.T9tZxFKqg08.
[iii] Gqubule and Ntingi, City Press, 3/25/12 http://www.citypress.eo.za/Business/News/Bricsmove-to-unseat-US-dolIar-as-trade-currency-20120324.
[iv] McWhinnie, “IMF Credits Gold as a Safe-Haven Asset,” Kitco Commentary, 4/6/12, http://www.kitco.com/ind/McWhinnie/20120416.html:”
[v] See Katusa, “Never Underestimate Country Risk,” Casey Research, 4/3/12, https://www.caseyresearch.com/never_underestimate_country_risk/.
[vi] See Budyak, “Getting Your Head Out of the Model: Due Diligence and Developing International Cost of Capital,” 12 Business Valuation Update 5 (May 2006).
[vii] See Harvey, “The International Cost of Capital and Risk Calculator,” http://faculty.fuqua.duke.edu/~charvey/Research/Working_Papers/W35_The_international_cost.pdf.
[viii] Markowitz, Portfolio Selection: Efficient Diversification of Investments (Wiley, 1959).
[ix] See Faber, “The Endowment Portfolio,” World Beta, 5/28/07, http://www.mebanefaber.com/2007/05/28/the-endowment-portfolio/.
[x] See Damodaran, “Measuring Company Exposure to Country Risk: Theory and Practice,” http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/CountryRisk.pdf (September 2003).
[xi] See remarks by Eric Spangenberg, dean of the Washington State University College of Business, http://www.business.wsu.edu/academics/Finance/Pages/GaryBrinson.aspx (December 2010).
[xii] Brinson, “The Future of Investment Management,” 61 Financial Analysts Journal 24 (July/August 2005).
[xiii] See Harvey, supra note 7; International Cost of Capital Report 2011, (Morningstar, 2011), http://ccrc.morningstar.com/PDF/Methodology/(Methodology)%20Int’l%20Cost%20of%20CapitaI%20Report.PDF
[xiv] Budyak, “Developing Discount Rates in Global Environment;·9 VLR 4 (January/February 2006).
[xv] See data compiled by Trading Economics, accessed at http://www.tradingeconomics.com/greece/government-bond-yield