International Valuation (Working Post)

How to value a company abroad? There is a lot of discussion about the topic, so I'll try to give my point of view, based on what I have been reading. I'll start with a simple example and will complicating it so more questions will come out.

1.1) First of all, we start with a diversified investor from the Unitade States (US) valuing a US company. The example is about US because is our best proxy of an efficient market, where all the theory we find in corporate finance books apply.

This looks as a simple question. We will use WACC method and for that we will need to assess the cost of equity (re) and debt (rd), the leverage ratio (D/E) and the corporate tax rate. For cost of equity we use CAPM and have to asses the risk-free rate (rf), the market premium (mp) and the company's beta. Here we start having to accept some controversial premises.

I still have to talk about CAPM parameters...

For the cost of debt we have to remember that we are interested in the tax shield provided by its debt, so we have to find out a number that reflects the cost of the actual debts weighted by the size of each debt issued. This demand some balance sheet research. For the leverage ratio, if the company is around the industry optimal leverage ratio, we can consider this industry leverage ratio in the equation, as in the long run, we expect that this company leverage ration oscilates around the industry ratio. For the corporate tax rate, we need to understand the tax law or to spend somemore time researching the balance sheet.

1.2) When an american company is evaluating a project, with premises we have to change? There is field for more discussion. If the project has the same risk as the company's other projects, we can use the WACC calculated for this firm. This imply some things.

The cost of equity is the same. However, for the cost of debt we should use the best aproximation for the cost of a new debt issue. Sometimes we use the average cost of debt that the company already have. Although, this reflects past events. As WACC should reflect that we are buying a new asset financed with the same leverage ratio of the company, we should try to figure out how much this debt would cost in the market.

If we consider that we can asses ths new cost of debt with a simple market observation. We can get the yield of tradable corporate bonds of companies with same credit rating. If the company hasn't a credit rating, we should look at similar companies in the market. Another option is the company just ask the banks how much they are charging for a new debt issue. An argument against it could be that, depending on the size of the project, even if it is financed with the company accumulated profits (equity), we can consider that part of the old debt is also financing the new project, as the project is not big enough to change the leverage ratio. This will also apply
for leverage ratio. As the risk profile is the same, leverage ratio will be the same, if the project is not big enough to change company's leberage ratio. Tax rate will be the same.

For projects with different risk profile, or big enough to change the leverage ratio, we can have another discussion in the next topic.

There is one flaw in the posed solution. CAPM consider a diversified investor. As we know, companies are not diversified across industries. What the solution?

1.3) When an american company is buying another american company, what premises we have to change? I don't think we should change any premise, if we look at this company as a new project. However, most of the target companies are big enough to change capital structure, if they are all equity financed, and sometimes have a different risk profile. So I suggest to use APV in the case of buying a company. For the cost of equity, we can estimate using CAPM, for that
specific company. The cost of debt would be the cost for a new issued debt. The tax rate can also be assessed for the specific company.

The diversified investor flaw also holds on this solution.

2.1) Now, let's go abroad. When a diversified investor in the US is valuing a company in a developed market, like germany, which changes have to be made?

Well, the difference now is that he is investing in a foreign market and has also foreign exchange exposure. The fact that he is investing in a foreign market changes anything? NO! Imagine a german investor in germany? As he is in a developed market, he would get CAPM parameters from its home country and the other WACC parameters from his homeland company and industry. So the US investor should do the same, but as he is exposed to foreign exchange risk, he has to add up the differential in inflation, which is the expected devaluation one currency will have to the other. This premise is based on purchase power parity and holds on the long run. The cash flows must be in german currency in this case!

But the american investor can make it also in another way. He can use CAPM parameters of it's own country, getting the beta comparing the company returns in dollar to the US market returns. This has to give us the same results, as the german beta times the german market risk will be the same as the american beta times the american market risk.

WHAT ABOUT THE RISK FREE and inflation differential? ARE DIFFERENT?

I consider using this methodology always, as will be usefull in all cases. The cash flows in this case must be in dollars. To convert german currency cash flows to dollar, I should use the forward prices for the currency, for the period I have it, and the differential in interest rates in the two countries for longer maturities, based on purchase power parity. We don't add any extra risk for the currency exchange, because we consider the company is not speculating on foreign exchange market and we suppose in the long run, the profit and losses due to the changes in the foreign exchange will yield zero.

2.2) When an american company is evaluating a project in germany, with same risk profile, we should follow th same methodology exposed before with the currency conversions explanined before.

2.3) An american company buying another company in germany with operation in germany

5) An american company buying another company in germany with international operations

6) A diversified investor valuing a company in an emerging economy like Brazil - currency risk

7) A diversified investor valuing a company in an unstable economy like... political risk etc