Monday, April 14, 2014

International Valuation: Around the World in 80 Steps

Valuation is critical to M&A. If you know the target’s value you can evaluate its price. Most of the MergerProf value discussions have centered upon the developed world-especially the United States. Developed nations use the valuation techniques championed here and taught in most business schools. People from emerging and developing countries sometimes ask if these techniques work in their markets. The answer is yes, but with important implementation caveats. The United States and the developed world are blessed with good quality readily available data. This aids in the implementation of the theory. Nonetheless, for emerging markets it is possible to establish workable cost of capital and other valuation estimates.

All valuation boils down to three questions:

1)     What are the cash flows: use the standard recipe of EBIT(1-t)+depreciation-
       (CAPEX+Working Capital Increases)
2)     When are they paid or received: gets to the time value of money based on a “risk
        free” government bond rate.
3)     How sure are we in the estimates: concerns the risk premium

The combination of 2 and 3 above give us the rate used to discount the cash flows. So for a Chinese company looking at another Chinese firm in a purely domestic transaction the procedure is relatively straightforward. There is a Chinese government rate and betas can be estimated from foreign peers. Damodaran's website provides useful country market risk estimates.

It gets more complicated when looking at cross border transactions involving two or more countries. The following discussion is limited to countries in emerging versus developing markets. The later have  difficult to gauge legal and political risks (e.g. expropriation and limited rule of law). In these countries, use a country risk premium or a modified payback rule-get your investment back ASAP before the local government blocks your returns.

Let’s turn to a simple situation of a U.S. firm buying a Brazilian firm. Two approaches as follows:
1)     Local Approach
     a)     Forecast local Brazilian Real cash flows
     b)     Determine local discount rates using project specific betas and capital structures
     c)     Calculate discounted Real cash flows using local Real rates
     d)     Spot the discounted Brazilian Real cash flows back into USDs in the FX market

2)     Centralized Approach
     a)     Forecast local cash flows
     b)     Convert the local Real cash flows into USDs using Interest Rate Parity
     c)     Discount the converted cash flows with USD home currency rates using project
             specific betas and capital structures into a USD project present value

The second approach is more common. Executives prefer to think in home currency terms, and accounting considerations favor this approach as well.

Taxes are a major consideration in structuring cross border transactions. Shifting taxable income to low rate countries thru various tax structures is a major reason U.S. firms have so much cash “trapped” offshore. Taxes also impact the repatriation of cash thru withholding taxes. My advice-get good legal and accounting tax experts.

As my favorite philosopher Yogi Berra noted-in theory there is no difference between theory and practice, but in practice there is. The same is true for international valuation. Get the cash flows right, and then think about the specific cross border risks that could block the receipt of those cash flows.


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