Lecture 13 Valuation in EMs Flashcards
Weighted average cost of capital (WACC)
Average cost of equity, re ,and debt, rd , weighted by the proportion of equity and debt on the firm’s balance sheet
WACC = E/(D+E)re + (D/(D+E) rd (1-t)
Where t is the tax rate (interest payments are deductible).
Market values of D and especially E should be used in the weights.
The corporate bond yield is typically used to measure the cost of debt. The hard part is estimating the cost of equity.
An asset’s cash flows are in local currency. How to get to a U.S. dollar valuation?
— Convert the cash flows to dollars using forward FX rates and discount them using a dollar-weighted average cost of capital (WACC); or
— Discount local-currency cash flows with a local-currency WACC. Convert the local currency valuation into dollars using the spot local currency/dollar exchange rate.
If interest rate parity holds, the two approaches should provide the same result.
What is Capital Asset Pricing Model (CAPM) ?
The Capital Asset Pricing Model (CAPM) is a financial model used to determine the appropriate required rate of return of an investment, given its risk relative to the market. The model is based on the premise that investors need to be compensated in two ways: time value of money and risk.
The CAPM formula is:
Ri = Rf + b(Rm – Rf ) + ui
What’s the theory behind CAPM
Diversification.
Firm specific risk can be diversified away (don’t expect to be compensated). But investors should be compensated for systematic risk.
In the CAPM, systematic risk is measured by beta. Nearly all assets are exposed to systematic risk, but to different degrees as measured by their betas.
Problems with using CAPM for emerging markets
If a market is not fully integrated into global markets, local risk factors are likely to be important to the cost of capital and need to be taken explicitly into account.
Not clear if country risk accounted in beta.
Alternative to CAPM for emerging markets
Replace the U.S. risk-free rate with a sovereign bond yield (or, equivalently, to add the sovereign spread to the U.S. risk-free rate) and make some adjustment for equity risk.
Cost of equity = sovereign yield + b*equity risk premium
Goldman Sachs model
To address low betas in emerging markets, GS model adjusts the estimated beta upward by the ratio of the volatility of emerging market (EM) to developed market (DM) returns, (oEM/oDM), and to use a country’s sovereign yield (SY) to capture country risk.
Problem: Not based on theory, and EMs don’t have low betas now unlike 1990s.
Damodaran model
Proposes ramping up the sovereign yields in a cost of equity model by multiplying them by the ratio of the volatility of local-market equity returns (oEquity) to sovereign debt returns (oDebt).
CSFB (now Credit Suisse) model
hard to understand
Not derived in theory
It is not clear why the expected local equity returns should vary on a one-to-one basis with sovereign yields
Country credit rating model
Estimates the cost of equity using survey-based credit ratings.
An advantage is CCR can be used to estimate the cost of equity or debt for countries that do not have equity or have not issued sovereign bonds
Regression that uses global equity and sovereign bond data
Regress emerging market equity returns on global equity returns and sovereign bond yields.
Pro: no double count country risk
Con: Temporally change beta
Citigroup’s two factor cost of equity model
Includes two betas to measure global factors through stock beta and local factors through bond beta.
Optimal investment criterion is…
Accept all projects whose NPV > 0 when future cash flows are discounted using a required rate of return calculated using the project’s beta.
Why not discount dividends?
Discounting expected future FCFs with the WACC provides an estimate of the enterprise value of the firm — the present value of free cash flows to the firm.
Discounting expected future dividends at the rate required by shareholders (cost of equity) provides an estimate of the value of the stock — the present value of cash flows to the shareholders.
