Recent events put the focus on your international valuation toolbox

Valuation professionals cannot afford to ignore what is happening in the global economy, especially in light of recent events. The devaluation of the Chinese Yuan has triggered a debate on the potential impact on American businesses. Then there’s the Fed’s decision on whether or not to raise interest rates—a decision that will be made at its upcoming September meeting.

In today’s economy, it is rare for a U.S. company to be completely insulated from the rest of the world. It could be as simple as having to deal with suppliers, competitors and/or customers located abroad, but it could also extend to having physical operations in foreign countries. Exposure to other countries typically creates new sources of risk that need to be incorporated in valuations.

One of the first decisions a valuation analyst needs to make is whether to reflect country risk in the projected cash flows or in the discount rate (or a mixture of both). “While ideally one would prefer to incorporate the incremental country risks directly in the projected cash flows, the reality is that it can be very difficult to develop truly “expected” projections (i.e., probability-adjusted) in an international setting, especially when dealing with countries where lack of reliable data prevails” Carla Nunes, a senior director at Duff & Phelps, tells BVWire.

Most analysts end up adjusting the discount rate when attempting to capture country risk. Several international cost of capital models are available, but it can be challenging for practitioners to find the appropriate underlying inputs. Developing robust inputs can be time-consuming and cost prohibitive for many valuation practitioners, but simply selecting a subjective country risk premium is not likely to be a defensible alternative. “We live in an environment where adding an ad-hoc country risk premium to the discount rate is no longer acceptable,” says Duff & Phelps director Jim Harrington. Practitioners see their valuations scrutinized by auditors, the SEC, the IRS, foreign tax authorities, courts, and other regulatory bodies. “Your valuation conclusions will be more defensible if you can corroborate your estimated country risk premium with third-party sources,” he adds.

Fortunately, there are some readily-available resources, all with their own pros and cons, of course. For example, Professor Aswath Damodaran (New York University Stern School of Business) publishes country risk-adjusted equity risk premia on his website for a variety of countries. However, there are a number of caveats posted on his website about the usage of his data, and he explicitly indicates that it was never his intent for it to be used in the legal arena.

The Duff & Phelps 2015 International Valuation Handbook – Guide to Cost of Capital is a new resource providing country-level country risk premia, relative volatility factors, and equity risk premia, which can be used to estimate country-level cost of equity capital globally, for up to 188 countries, from the perspective of investors based in up to 56 countries. BVR has a webinar on how to use this annual publication, and you can access it—at no charge—if you click here.

Also look for an early-2016 Business Valuation Update article by Jim Harrington and Carla Nunes for a more detailed discussion of country risk rating sources, as well as how they can be converted into usable country risk premia information.