Friday, April 16, 2010

Currency Choices in Valuation

I am currently in Bogota, Colombia, doing a seminar in risk. One of the topics that came up yesterday was about the choice of currency to do a valuation in, and how it affects your inputs. In particular, the question that I was asked was whether an analyst should value a Colombian company in Colombian pesos or US dollars, and the implications of this choice. Here is how I responded:

Which currency should I do my valuation in?
If you do your valuation right, it should not matter. Your value for a company should be the same, no matter what currency you choose to value it in. Thus, a company that is under valued by 20%, when you do your valuation in pesos, should remain under valued by 20%, when you do your valuation in US dollars.
Given this proposition, you should pick the currency with which you are most comfortable with and where it is easiest to get the financial information. My instinct, given the latter requirement, is to do valuations in the local currency since most financial statements are richer and more detailed in the local currency. Your choice of currency should not be a function of the investor for whom you are doing the valuation. Thus, you should not try to value a Colombian company in US dollars, just because the investor for whom you are doing the valuation is dollar based.
 
How is my discount rate affected by my currency choice?
In the context of discount rates, the input that is most influenced by the currency choice is the riskfree rate. If you work with a higher inflation currency, the riskfree rate will be higher. In the Colombian context, the Colombian peso riskfree rate was 6.5% and the US dollar riskfree rate was 4% last week. The difference of 2.5% is entirely attributable to differences in expected inflation.

Just as a side note, while getting a US dollar riskfree rate is easy (I used the T.Bond rate), I had to work a little harder to get the riskfree rate in pesos, since the peso-denominated Colombian government bond does have some default risk embedded in it. In particular, I subtracted out the default spread for the Colombian government (about 2%) from the bond rate (8.5%) to get to the riskfree rate.

The other inputs remain pretty stable. Betas should measure the business risk of the company. I have never understood the rationale of a widely used practice of using betas against the S&P 500, when doing dollar based analysis, and switching to betas against local indices, for local currency analysis. Those of you who follow my work know that I am firm believer in using sector or bottom up betas. For Ecopetrol, the Colombian company, I estimated a beta of about 0.80, based on the fact that it was an oil company, and used that beta for both US dollar and Colombian peso analysis. Even more dangerous is the practice of using the US equity risk premium, for US dollar analysis, and the much larger Colombian equity risk premium, for peso analysis. The company is a Colombian company and you cannot make the country risk go away by switching currencies. Both the dollar and the peso analysis therefore should use the higher Colombian risk premium.

As a final note, the cost of debt should be in the same currency that you estimate the cost of equity in and this is true no matter what currency the company actually borrows in. Therefore, if the company borrows in US dollars but you are doing your analysis in pesos, you will have to restate the cost of debt in peso terms.

How are my cash flows affected by my choice of currency?
The key rule here is that your cash flows have to be in the same currency as your discount rate. Thus, if you decide to do your analysis in pesos, you cash flows have to be in nominal pesos. If you decide to do your analysis in dollars, your cash flows have to be in nominal dollars. If it is a company with Colombian operations, this will often mean that you have estimate the cash flows in pesos and convert them into dollars. You have to use forward or expected exchange rates (and not the current spot rate) to make the conversion. In fact, if you want to preserve consistency, your expected exchange rate has to be computed from either interest rate or purchasing power parity. In the context of Colombia, for instance, the 2.5% higher inflation in Colombia that I have built into the riskfree rate will translate into an expected devaluation in the peso of about 2.5% a year.


Can I avoid this currency choice altogether?
You could, if you do your analysis in real terms. Thus, your discount rate has to be a real discount rate; the real riskfree rate is about 2% (I used the inflation-indexed US treasury to get this) and you can build the rest of the inputs on top of this rate. Your expected cash flows should be real cash flows; thus, you cannot count the inflation component of growth. Again, if you do it right, you should get the same value.

The bottom line: Make your choice of currencies at the start of the process and stay consistent with that choice all the way through. If you are wrong about expected inflation, it will cancel out - both your discount rates and cash flows will change. If you are inconsistent about inflation, applying one rate to cash flows and another to discount rates, your valuation cannot be salvaged.

19 comments:

James said...

Professor Damodaran, many thanks for the post. Would you suggest that all valuations be done in real terms (whether US or global), with inflation being an input variable (yearly, for free cash flows) that the analyst could choose to input or not?

It seems like the reason to itemize inflation would be if the analyst felt it would change from the current rate and wanted to incorporate that year-by-year prediction. But in that case, is it still OK to tie all yearly cash flows back to a single discount rate -- or would the analyst need to estimate an inflation-adjusted discount rate every year if inflation itself varied every year?

Many thanks again.

Aswath Damodaran said...

The only problem with real analysis is that taxes are computed based upon nominal earnings (not real earnings). Hence, it becomes much more difficult estimating and using tax rates. That is why, if inflation is low, as it is in the US and Europe, and stable, it is still better to stick with nominal analysis. If inflation is high and unstable, switching to real analysis makes sense.

Aseem Madan said...

Hello Prof,

How do we estimate the Terminal Growth Rate ( emerging vs developed markets)? Please guide.

Thanks much!

Aswath Damodaran said...

The rules are exactly the same. The stable growth rate has to be less than equal to the growth rate of the economy and the riskfree rate is a good proxy for the growth rate of the economy. Thus, your stable growth rate will be higher when you work with a high inflation currency and lower with a low inflation currency and even lower in real terms.

Karthikeyan Kannapiran said...
This comment has been removed by the author.
Karthi said...

My understanding has been that generally with terminal value you typically use either the ggm or multiple approach that reflects a truly mature business. Obviously any mature business will have growth that is consistent with economic growth.

The problem in emerging markets is that even after 10-20 yrs companies still generate strong cash flow/profit growth.

When investment banks usually value a business in emerging markets they generally make a very simple assumption that in 10 yrs time the economy grows into a mature market.

The biggest problems in valuing banks in emerging markets is that terminal value as a % of npv of cash flows is often greater than 100%, due to the fact the loan book grows faster than the rate at which retained profits can support regulatory capital requirements which results in capital needing to be pumped into the business (negative cash flows). Professor what are your views on this valuation debacle?

Brad said...

Applied Corporate Finance - Disney Valuation ERROR - page 12.56

Please check email sent under the same title for details.

PorshaCoghlan梁子珠 said...

Learning makes life sweet.......................................................

Karthi said...

Brad,

Was that comment relating to my post, if so I haven't received the email as of yet.

GeraldF_Rotter雅慧 said...

Hello~Nice to meet you~..................................................

Svabbi said...

Hi Professor. Love your blog.
In regards to the Icelandic risk free rate. Would you then say that the risk free rate is 3%? Given that nonindexed govornment bonds yield 7% and the CDS on Iceland is 4%?
The praxis here in Iceland is to use the govornment bonds without takin into account the default risk. Would you say that is incorrect?
Best regards

abhishek m said...

hello Professor

thanks a lot for such a wonderful blog......

Mahesh Sethuraman said...

Awaiting ur thoughts on the GS-SEC hearing...

Rozza said...
This comment has been removed by the author.
Rozza said...
This comment has been removed by the author.
Cool said...

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seni bana yazmışlar said...

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Shaji Nair said...

Hello Professor, I m trying to value Eclerx(only pure listed KPO in India). It generates most of its revenues from US(74%) and Europe(21%).
I tried valuing the company in domestic currency considering Indian Risk free rate and assumed Indian ERP around 8.5%.
I also tried valuing the company in US $ considering US risk free rate and assumed Indian ERP.
The results are different depicting a higher return potential while valuing in $ terms.
I have read some of your sessions and musings and I am a bit puzzled as to which 1 is right.
Because according to you, one approach is to value using discount rate in which a company derives its revenues/value (in this case US $ or blended US and Europe).
I have kept growth rates same in both currency (in sync with its US revenue growth) and ignored appreciation/depreciation of domestic currency.

Can you put some light on how to go about valuing this company?