Tuesday, April 17, 2012

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..

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.


Anonymous said...

Hope other nation do not get into this game .eagerly waiting to read your next post too

Unknown said...

Prof. Damodaran,

This a jewel for whom make a living doing finance here in Venezuela. It is really a challenge to value or to have a company.

Thanks for the post

HaLin said...

Interesting perspective, Professor.

I prefer bumping up my required rate of return to reflect idiosyncratic geopolitical risk (sovereign, regulatory, nationalisation et al). As you note, there is no perfect way of accounting for this risk but a stringent hurdle rate for filtering my investment prospects typically works reasonably well.

However, there are risks that cannot be hedged away (think the recent PNGRB ruling in India, retrospectively slashing natural gas compression and transportation tariffs drastically). I think little can be done about these unknown unknown, except perhaps not assume the risk at all. The swipe of a pen is sometimes mightier than the threat of war, in the investing world.

Also, as a general approach, what do you think of the idea of using a hurdle rate as the discount rate in DCFs? Having used CAPMs, I have grown to trust my required rate of return as a measure of 'risk'. While I agree that some businesses have cash flow characteristics that are inherently riskier than others, the hurdle rate approach has worked well. Would really appreciate your experience here.

Lucas Tacconi said...

Hello professor. Interesintg article, but I think you are missing a bit in the YPF case in Argentina. Repsol was supposed to invest a serious budget in oil research and development. They didn't. Nowadays (and since 6 or 7 years) the YPF gas stations operate at 50% of their capacity during the week, and in the weekends they run out of oil. All of them. YPF is all over the country and it is the largest and more popular refinery here. So, I think it was about time that someone stop this. You should see the infinite line of cars that are in every YPF gas station every single day. I don't think it's fair for the society, I'm pretty sure that goverments should take part when society is threatened. I'd like to hear more comments about it. Thank you very much,

Eng. Tacconi Lucas

Aswath Damodaran said...

I don't have a problem. Then, pay them the market price and buy them out. Don't nationalize YPF. Repsol is not the most efficient company in the world and you see its inefficiency reflected in its market value (and in the market value of YPF).

The Dumb Money said...

Nice post. Personally I think there are only two ways to account for this:

1) Perform an honest-to-goodness insurance company-derived actuarial analysis to reduce expected cash flows (I think this is what you are beginning to get at in Option 3, Step 2, but it really needs to be a more formal actuarial analysis, analogizing nationalization to large weather events like hurricanes), or;

2) Don't invest in companies with significant holdings/business in such countries. There are many fish in the sea.

Side note: I like your blog and I really wish you could change the set up so that people could also log in using Disqus, Twitter, Facebook, Tumblr, etc., as well.

I think everything else is likely just guessing.


Danm said...

Professor Damodaran,

Thank you for your posts, as always. I was wondering, what about using some sort of market-driven metric to determine the liklihood of default? For example, you mention the disparity of Venezuelan and Russian PE ratios vs. their emerging market counterparts; could we use that to drive this figure? This would not be terribly useful as protection vs. unexpected actions such as with YPF, but could be useful with valuations for corporations operating in known mercurial locations.

The Dumb Money,

Much of what we do IS guessing - we will *never* have all the information, it's what we do with what we have that matters. There's a delicate balance of how long we wait or how much we invest in getting exact information; at some point you must make a decision or recommendation.

Dan McAllister

The Dumb Money said...


Oh I agree, but there is a significant qualitative difference between coming up with a discount rate or a growth rate, on the one hand, and simply "assigning a probability" of nationalization, on the other. The former at least have numerical inputs, prior growth rates, WACCs, etc. -- bases for the assumptions. The latter has nothing unless an actuarial analysis is performed. I apologize if I was not clear on that. It's one man's opinion. I'm well-aware that the entire calculation of value involves many assumptions.

My recommendation would be not to invest in such companies/countries, and that is what I follow in my own investing. In this regard, South Africa is potentially a growing risk as well....

Best wishes,

The Dumb Money

Eduardo Moreira said...

As usual, relevant and insightful, Professor.

Something I wonder about is whether considering a high discount rate and embedding a risk premium (should we?) for the "going concern" portion of your Method C could be double-counting some of the risk.

I wonder about that because in the first place, one of the reasons interest rates are high in those countries is exactly the markets' perception of a higher likelihood that governments will "misbehave", right?

Hope all is well at Stern!

Anonymous said...

What your theory doesn't account for, is the fact that acquiring a business cheap (due to nationalisation risk as you say) increases the risk of said nationalisation happening when the government becomes convinced you swooned them out of a good asset

Mauricio said...

I think you can effectively deal with nationalization risk in some way. Motives to Nationalize (Political or Economical). It seems that Argentina motives are economical (check Argentina economy today) and you can related the need of resources by a country to nationalization. ¿Why Repsol YPF and not other company? Repsol find oil resources, demanded today at attractive price.

Some says that the company in Argentina was not operating efficiently. If this was the case, the market price should react accordingly, but this doesn't happened.

Best regards to all

However, define a line that allow to differentiate political or economical motives, is not an easy job.

Anonymous said...

Great topic and a very relevant discussion for growth markets as well.
Between, I am a little perplexed with the sample valuation ( I know its just to illustrate your point, but I never saw you making a mistake in the past and am wondering if I am missing anything here ). I thought the DCF value was 449 and not 491. Also the math doesn't add up. What am I missing?

A discounted cash flow valuation of the company generates a value of 449 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 = 491 (.8) + (491 *.5) (.2) = 212 million VEB

Aswath Damodaran said...

You are right. I mangled the numbers in the valuation in the post (though the excel spreadsheet is fine) and I fixed them now.
The Dumb Money,
I don't disagree with you but this is one risk that actuaries will have a tough time with. It is easier to deal with forces of nature and even terrorist attacks than it is to judge how a fickle head of state will act. You could try to buy insurance against nationalization and reduce your cash flows by the cost...

The Dumb Money said...


I did not expect a personal reply and I'm honored!

What you say is precisely why I think a good strategy is not invest in such companies/countries.

Though I can also suggest another. Move beyond valuation and math, into history. History suggests natural resources companies, bank companies, and media companies, are the most likely to be nationalized. History also suggests that unless a country goes fully communist (Cuba), only large "important" companies get nationalized. Accordingly, an alternatively viable strategy is, when investing in such countries, avoid those three categories, and look for small-cap companies (these days, ones that are not RTOs).

This is why I think Pepsi will be ok buying Wimm-Bill-Dann, and Walmart will be ok buying that South African grocer, whereas I would not dare put money in South African natural resources companies right now. I also much prefer the small cap Brazilian ETF, "BRF" to owning even large Brazilian companies. I would not even think about touching most South American natural resources companies, particularly those involved in precious metals or oil.

All best,

The Dumb Money

P.Neoliberales said...

Dumb Money,

If you just don't invest in companies that have interests in "emerging countries", then you just don't invest in most of mining and oil companies as most of the resources are there. You just have to take into account the extra risk, the post gives a view on how to account for the extra risk.
Companies that have to put a lot of upfront money to receive a cash flow in the next 30 years are all at risk, and not only in "lax law" countries, a couple of rulings pop to my mind against Highways concessions or Airport concessions in the US or in the UK. This is a kind of risk very underestimated by investors.

Shiv said...

I have a simple policy for companies where governance is suspect (i.e. public sector undertakings/GOOG/FB/BRK). Don't invest in them! But YPF's situation makes me uncomfortable well governed private sector participants like BP, RDS and several resource owners which are exposed to nationalization risks. I guess the best was to handle the risk is by diversification of country risk.

Walter Klein (Argentina) said...

Profesor Damodaran:

Uno de los principales problemas que se encuentran luego de analizar estos casos es el ocultamiento de información relevante para que los inversores puedan valorar correctamente a la firma. Da cuenta de la dificultad de las instituciones de control (comisión nacional de valores) de transparentar la información generada por las empresas hacia el público inversor. Estas imperfecciones de mercado acentúan los problemas de agencia a la hora de asignarle el valor a una firma y refuerza más que nunca que las firmas que cotizan en mercados de valores suelen estar sobrevaluadas o subvaluadas dependiendo más a acciones de comunicación y marketing que ha circunstancias del negocio mucho más objetivas. Los mercados regulados terminan comportándose como se comportarían mercados desregulados o informales. El ocultamiento de información que perjudica el valor de la firma es un hecho que no terminó con la ley Sabarnes Oxley y otras porque siguen ocurriendo lo mismos hechos aún luego de su sanción. Es muy común ver empresas globalizarse en África, Latinoamérica, Asia o Medio Oriente sin control y regulaciones depredando todos los recursos y sin tomar los recaudos ambientales necesarios y en consecuencia generando pasivos ambientales difíciles de medir, con el consecuente riesgo de sobrevaloración para el perjudicado. Es correcto pensar que es imposible encontrar una prima psicológica que determine una posible reacción de un gobernante para agregar en el modelo de valoración a riesgo, pero es un antecedente importante a tener en cuenta, encontrar una prima de riesgo para estados débiles propensos a proteger a supuestos inversores que buscan estabilidad y seguridad jurídica o estados fuertes dispuestos a proteger su soberanía y población. La nacionalización de empresas afecta el valor de la firma sino habría que fijarse en los casos de la banca y seguros en US y Europa para no ir demasiado lejos en el tiempo que usted no comenta nada al respecto en este artículo.

El debate pasa por la incapacidad de los organismos de regulación para que la información publicada por las firmas sea transparente, este caso no es el único de ocultamiento de hechos significativos que afecta el valor de las firmas.

Las grandes empresas tienen un valor mayor dependiendo de, si la política del gobierno esta dispuesta a poner al Estado como prestamista de última instancia (sea por razones válidas o discutibles) y esa situación queda expresada en su valor, en ese caso el capital propio siempre es mayor que cero aun en situaciones de insolvencia financiera.

Uno de los problemas para la valoración de empresas es el acceso a la información y esa situación se magnifica cuando más nos alejamos geográficamente del lugar donde nos sentimos cómodos, sea por cultura, idioma, historia, legalidad, moneda etc. Esa incomodidad manifiesta obliga al inversor a exigir más certidumbre, que no todos los gobiernos están dispuestos a dar por diferentes motivos. En ese momento puede tomarse la decisión de NO invertir o utilizar la fuerza sea corrupción o militarización para comprar esa certidumbre.

Los efectos sobre el valor de la firma de los gobiernos vía nacionalización supone un mayor riesgo para empresas gestionadas irresponsablemente, ineficientes e incapaces de entender el contexto político que los rodea, pudiendo hacer un paralelismo con las empresas que se exponen a una OPA hostil, suena bastante lógico que la empresa nacionalizada busque un aprovechamiento de los recursos con otros fines no asociados con la rentabilidad sino con intenciones más estratégicas y de sustentabilidad del propio país, por ejemplo preservar fuentes de trabajo, estabilidad energética o de infraestructura etc. Que la gestión anterior fue incapaz de ver.

La dinámica de los sucesos económicos nos obliga a replantearnos muchos aspectos de las finanzas corporativas incluidas la valoración de empresas.


Prof: Walter Klein


Now the risk of confiscation is a real possibility in some developing countries. And the way these thinks work is blame the large international companies doing business in your country and blame them for all your countries Ills that way you can justify confiscation of parts of their business. And normaly theirs a chain reaction when one country begins confiscation of a companies assets than many other countries my follow suit. The risk of confiscation is much much higher than most investors ever realize. And by the time they finally do realize it's usually to late.