Governments and Value: Part 1 - Nationalization Risk

I have been writing about valuation for a long time and for much of that time period, I chose to ignore the effects, positive or negative, that governments can have on the value of businesses. Implicitly, I was assuming that governments could affect the value of a business only through the tax code and perhaps through regulatory rule changes (if you were a regulated firm), but that  a firm's value ultimately rested on its capacity to find a market for its products and generate profits from these products. The last five years have been a wake-up call to me that governments can and often do affect value in significant ways and that these effects are not restricted to emerging markets.

The news story that brought this thought back to the forefront was from Argentina, where Cristina Fernandez, the president, announced that the Argentine government planned to nationalize YPF. The ripple effects were felt across the ocean in Spain, where Repsol, the majority owner of YPF, now stands to lose several billion dollars as a consequence. Not surpringly, the stock price of YPF, already down about 50% this year, plunged another 21% in New York trading. If you own YPF stock, my sympathies to you, but it is too late to reverse that mistake. However, there are general lessons that we can take away from this sorry episode about how best to incorporate the possibility of government capriciousness into what you pay for shares in a company.

1. Intrinsic value and nationalization risk
There are three components to intrinsic value: cash flows (reflecting the profitability of your business), growth (incorporating both the benefits of growth and the costs of delivering that growth) and risk. If you have to value a company in a country where nationalization risk is a clear and present danger, the obvious input that you may think of changing is the risk measure. After all, as investors, you face more risk to your investments in countries with capricious heads of state or governments, than in countries with governments that respect ownership rights (and have legal systems that back it up).
There are three options that you can use to incorporate the effect of this risk on your value:


Option 1- Use a "higher required return or discount rate": If you are using a discounted cash flow valuation, you could try to use a higher discount rate for companies that operate in Argentina, Venezuela or Russia, for instance, to reflect the higher risk that your ownership stake may be taken away from you for less-than-fair compensation. The problem that you will face is that discount rates are blunt instruments and that the risk and return models  are more attuned to capturing the risk that your earnings or cash flow estimates will be volatile than to reflecting discrete risk, i.e., risks like survival risk or nationalization risk that "truncate or end" your investment.


Option 2: Reduce your "expected cash flows for risk of nationalization: You can reduce the expected cash flows that you will get from a company incorporated in a "nationalization-prone" market to reflect the risk that those cash flows will be expropriated. While this may be straight forward for the near term cash flows (say the first year or two), they will be much more difficult to do for the cash flows beyond that time period.

Option 3: Deal with the nationalization risk separately from your valuation: Since it is so difficult to adjust discount rates and cash flows for nationalization risk (or any other discrete risk), here is my preferred option.
Step 1: Value the company using conventional discounted cash flow models, with no increment in the discount rate or haircutting of the cash flows. The value that you get from the model will be your "going concern" value.
Step 2: Bring in the concerns you have about nationalization into two numbers: a probability that the firm will be nationalized and the proceeds that you will get if you are nationalized.
Value of operating assets = Value of assets from DCF (1 - Probability of nationalization) + Value of assets if nationalized (Probability of nationalization)

To illustrate, consider Dominguez & Cia, a Venezuelan packaging company, which generated 117 million Venezuelan Bolivar (VEB) in operating income on revenues of 491 million VEB in 2010. A discounted cash flow valuation of the company generates a value of 483 million VEB for the operating assets. Assuming a 20% probability of nationalization and also assuming that the owners will be paid half of fair value, if nationalization occurs, here is what we obtain as the nationalization adjusted value:
Nationalization adjusted value = 483 (.8) + (483*.5) (.2) = 435 million VEB
Subtracting out the debt (291 million) and adding cash (68 million) yields a value for the equity of 212 million VEB. At its traded equity value of 211 million VEB, the stock looks fairly priced. If you download the valuation, you can see that I have incorporated the high operating risk (separate from nationalization risk) in Venezuela with a higher equity risk premium (12%) and the higher inflation/interest rates in Venezuela with a higher risk free rate of 20%. In particular, play with the nationalization probabilities and the consequences of nationalization to see how it plays out in your value per share.

Note, though, that my 20% estimate of the probability of nationalization is a complete guess, in this case. If I were interested in investing in Venezuelan (Russian, Argentine) companies,  I would spend more of my time assessing Hugo Chavez's (Vlad Putin's, Cristina Fernandez's) proclivities and persuasions than on generating cash flow estimates for companies. Since my skill set does not lie in psychoanalysis, I am going to steer away from companies in these countries.

2. Relative value and nationalization risk
How would you bring in the concerns about nationalization, if you value companies based upon multiples? One is to use multiples extracted from the country in question, on the assumption that the market would have incorporated (correctly) the risk and cost of nationalization into these multiples. To an extent, this is reasonable and it is true that companies in countries with high nationalization risk trade at lower multiples.

Note that while Russian and Venezuelan companies trade at a discount to their emerging market peers (and my guess is that Argentine companies will join them soon), you have no way of knowing whether the discount is a fair one.

The problem, though,  becomes more acute when you are not able to find enough companies in the sector within that country to make your valuation judgment. With Dominguez & Cia, for instance, you have the only publicly traded packaging company operating in Venezuela. If you decide to go out of the market, say look at US packaging companies in 2011, the average EV/Operating income multiple is about 10.51 in January 2012. Applying this multiple to Dominguez's operating income would generate a value of  1230 million VEB, well above the market value of 211 million VEB. However, you have not incorporated the higher operating risk in Venezuela (separate from the nationalization risk) and the risk of nationalization.

The bottom line with multiples is simple. If you do not control for nationalization risk, companies in countries which are exposed to this risk will often look absurdly cheap on a PE ratio or an EV/EBITDA basis. But looking cheap does not necessarily equate to being cheap..

Implications
While it is too late to incorporate the risk of nationalization in the value of YPF, you can adjust the estimated values of other Argentine companies. While the government of Argentina may argue that YPF was unique and that they would not extend the nationalization model to other companies, I would operate under the presumption of "fool me once, shame on you... fool me twice, shame on me" and incorporate a higher probability of bankruptcy into the valuation of every Argentine company. The net effect would be a drop in equity values across the board: that is the consequence of government action. There are other repercussions as well. A government that is cavalier about private ownership is likely to be just as cavalier about its financial obligations: no surprise then at the news that the default spreads for Argentina have surged after the YPF news.

In closing
While this post is about the "negative" effects of government intervention, it is possible that the potential for government intervention can push up the value of equity in other companies. In particular, the possibility that governments may "bail out" companies that are "too large or important to fail" may increase the value of equities in those companies as will the potential for government subsidies to "worthy" companies. I will come back to these questions in subsequent posts.

Returning again to the Argentina story, Ms. Fernandez was quoted as saying, "I am a head of state, and not a hoodlum". Someone should remind her that the two are not mutual exclusive, and the problem may be that she is both.