Valuation of Firms in Emerging Markets

VALUATION OF FIRMS IN EMERGING MARKETS

A practical approach to valuing emerging market companies

Submitted to Prof. Pramuan BUNKANWANICHA

By

Christian LAMHIEN

Date of Submission: May 12, 2014

2

Table of Contents

Abstract ............................................................................................................................ 3 I/ Literature review .......................................................................................................... 3

II/ A brief outlook on emerging markets today ............................................................ 4 1/ Emerging markets as key actors in the global economy ........................................................................ 4 2/ Challenges and weaknesses of emerging markets ................................................................................... 6

a) Cyclical slowdown ....................................................................................................................................................... 6 b) Structural slowdown .................................................................................................................................................. 6

III/ The role of emerging countries in financial markets ............................................. 7 1/ Economic Size vs Market Size .............................................................................................................................. 7 2/ Characteristics of Emerging Market companies ......................................................................................... 9

a) Exposure to country risk ....................................................................................................................................... 9 b) Corporate governance issues ........................................................................................................................ 10 c) Cross-holding issues ........................................................................................................................................... 10 d) Currency volatility ................................................................................................................................................. 11 e) Lack of comparables ........................................................................................................................................... 11

IV/ Current methods of valuation ................................................................................ 11 1/ DCF adjustments by practitioners ................................................................................................................... 12

a) Adjusting the cash flows ....................................................................................................................................... 12 b) Adjusting the discount rate ................................................................................................................................. 13

2/ Relative valuation in emerging markets ........................................................................................................ 20

V/ A practical guideline for valuation of emerging market companies ................... 20 1/ Some useful facts about DCF methods ........................................................................................................ 20

a) As a minority shareholder ..................................................................................................................................... 22 b) As a controlling stockholder ............................................................................................................................... 23 c) As a strategic investor ............................................................................................................................................ 24 d) Summarizing the three models ......................................................................................................................... 24

2/ A practical approach to adapt DCF methods for emerging markets ............................................ 24 a) Consistency in currencies .................................................................................................................................... 24 b) Estimating a cost of capital using the Damodaran approach ......................................................... 25 c) Estimating the cost of debt for emerging market companies ......................................................... 27 d) Accounting for one-sided risks ......................................................................................................................... 27

3/ A practical approach to adapting relative valuation for emerging markets ............................... 28 a) To increase size sample ........................................................................................................................................ 29 b) To mitigate difference in fundamentals ........................................................................................................ 29

VI/ Valuation of Vinamilk ............................................................................................... 30 1/ Brief presentation of Vinamilk ............................................................................................................................. 30 2/ Estimating Vinamilk’s Cost of capital ............................................................................................................. 32 2/ Estimating Vinamilk’s Cost of debt .................................................................................................................. 37 3/ Estimating Vinamilk’s Growth rate ................................................................................................................... 38 4/ Terminal value ............................................................................................................................................................. 40 5/ Value per share ........................................................................................................................................................... 40

CONCLUSION ............................................................................................................... 41

APPENDICE ................................................................................................................... 42 Vinamilk valuation input sheets ............................................................................................................................. 42

BIBLIOGRAPHY ............................................................................................................ 44

3

Abstract The goal of this paper is to define the issues specific to valuing firms in emerging

markets as to establish a guideline that comprehends steps and suggestions for these

issues. As opposed to Valuation in developed markets where there tend to be certain common practices, there is no clear « best practice » for emerging markets.

In this paper we begin by assessing the situation of emerging markets giving a brief outlook on their role in the global economy, the challenges they face and their situation

in the financial world. We then look at the difficulties that show up in emerging market company valuations and examine the current methods used by practitioners to overcome these difficulties. After reviewing these methods, we discuss how best to adapt valuation methods in order to overcome the technical issues. Finally we close the paper by applying the recommandations to the valuation of a typical emerging market company. The methodology used was to find out from the literature the current methods for valuing emerging economy investments. A literature study was also used to find out additional considerations applicable in such a valuation. A valuation of an emerging

market company is carried out using the process developed in order to gain experience of the practical applicability of the process.

I/ Literature review

Despite the large number of articles written on financial risks in emerging markets, very few really take the effort to suggest practical ways to take these risks into account. And when they do, they can disagree with one another (in the next parts we will examine in

4

which way they disagree). There are few articles that reveal all the methods that are

most commonly used by practitioners (certainly because these don’t really converge). Some do (Pereiro, 2006) but there is no exhaustive explanation of the methods used. The major problem we met during research is that few articles really consider the

practical aspects of methods suggested, which we consider as the most crucial part in valuation. Given the speed at which emerging markets grow, one must be able to find

practical ways to compute estimates (such as using proxies) when fundamentals lack (and they often lack given the relatively new historical data). However sources of practical methods are available (Damodaran) and not only in papers but also through webcasts that we strongly recommand seeing. Finally we made through this paper an

attemp to bring valuation in emerging markets a step further by putting available methods together and reviewing them with, again, a main focus on practicality.

II/ A brief outlook on emerging markets today

1/ Emerging markets as key actors in the global economy The term emerging markets was born in the 1990 for third-world countries that were going through important development. They have attracted a lot of attention since and

especially during the last decade for their rapid change. Since 2012, emerging markets accounts for more than half of the world’s economy in terms of GDP based on

Purchasing Power Parity, and figures show how important they have become. In 2010 :

• They burnt more than 55% of the oil consumed.

• They were responsible for 65% of the world’s copper consumption and 75% of the world’s steel consumption.

5

• They bought 52% of the world’s vehicules.

• They reprensented 87% of mobile phone subscriptions. • They accounted for more than half of the world’s exports and more than half of

America’s overseas sales.1

Though growth in emerging markets have slowed down recently, decreasing from 7,9% in 2010 to 4,9% in 2014, it still is more than twice the growth in advanced economies of 2,2%. And as they continue growing, it is estimated that within the next 5 years, more than 460 million people in emerging markets will enter middle class. Which such figures, emerging markets have become very interesting opportunities for investors.

1 Source : The Economist

6

2/ Challenges and weaknesses of emerging markets Despite their rise, emerging markets have shown some weaknesses in the recent years.

Though they still have room for growth since they need to « catch up » with advanced economies, it is not so natural to assume that they will be able to do so. Indeed their

recent slow down reflected the fragilities of their economy. As economist Greg Ip of The Economist (2012) explains, this slow down can be split up in two main categories, a cyclical one and a structural one. While the first one is being overcome, he says, the other is harder to tackle.

a) Cyclical slowdown After the 2008 crisis, emerging markets responded positively through important state intervention. China for instance invested heavily in welfare while Brazil used its state-owned banks to fill in for private credit. However shortly after, the Sovereign-debt crisis came to Europe and emerging markets were again affected since Europe is a large source of demand for these economies. Fortunately, policymakers in the emerging markets still have ways to respond. For instance their budget deficit is still at an acceptable rate of 2% compared to 6% in the advanced economies. Thus they can afford fiscal stimulus. Additionally, while Public debt amounts to over a 100% of GDP in

the rich world, it only amounts to 35% of GDP of emerging markets leaving room for more leverage. This leads to thinking that emerging countries still have the macroeconomic tools to sustain growth.

b) Structural slowdown But as these measures show, emerging markets depend significantly on state intervention. Having leverage over the economy is indeed helpful during a crisis, but in

the long run it can stifle competition, deprive the private sector of capital, deter foreign investment and finally it is a conduit for corruption.

7

It is also important to note that China has always been a major growth driver for

emerging economies as a commodity intensive economy feeding demand to its neighbors. Thus the fact that China is shifting to a less commodity intensive economy will have a negative impact on other emerging economies.

In a more direct way for investors, the strong presence of the state is reflected directly in the business. For instance, China codified the number of sectors in which state-

owned enterprise are to have a predominant if not monopolistic role. In the meantime, Russia has significant parts in all the oil and gas companies which are a major source of revenues for the country. Other emerging countries such as Vietnam impose strict limits on foreign investment in an attempt to limit foreign ownership of domestic companies.

Investors may be prohibited from owning more than a fraction of any one company, and they may also be restricted from repatriating profits from investing activities. Finally above the weak property rights most emerging countries often lack physical infrastructure, roads, transport and power.

III/ The role of emerging countries in financial markets As financial markets in emerging economies become larger, they represent a source of diversification for global investors. In addition to diversification, investors are attracted

by the high growth that implies higher stock returns than in developed markets. However if you look at emerging markets from a stock market perspective, shares available to foreign investors can still seem scarce.

1/ Economic Size vs Market Size Though in terms of GDP based on PPP, emerging markets represent the major part of

the global economy, their market capitalization is still weak compared to advanced economies.

8

According to MSCI, in 2013, emerging markets represented 13% of the global market

capitalization versus 87% for developed markets. A comparison has been made by the Economist between the world’s largest companies in terms of market capitalization and emerging countries’ total market capitalizations, showing how entire countries’ market capitalization can equal just a large multinational company.

A ratio that indicates how developed the financial market is for a country is the Market Cap/GDP ratio. As seen in the graph below (from MSCI), though some emerging countries have a large GDP, their market capitalization has room for growth given the size of their economy.

9

However it is important to notice that state ownership often results in surprising equity

market biases. For instance if you take the case of Russia, a large portion of its economy relies on energy. Since the Russian government detains a large stake in all the oil and gaz companies, there is already a huge part of shares taken. Thus Russia has a weak Market Cap/GDP ratio.

Finally this doesn’t necessarily means that there are no room for investments. First a weak Market Cap/GDP ratio essentially means that a large portion of firms are still not

listed and this will shift with growth. Second, investors can also resort to private equity if they are really interested in emerging markets companies.

2/ Characteristics of Emerging Market companies Emerging market companies vary significantly in terms of size, location and industry but there are specific characteristics most of them share.

a) Exposure to country risk

As mentioned earlier, factors such as macroeconomic volatility, regulatory or political change, enforcement mechanisms and poorly defined property rights have to be taken into account. However their exposure vary significantly. In almost every

emerging market, there are a few companies that derive the majority of their revenues outside the market : Tata Consulting Services in India and Embraer in Brazil are good examples, deriving less than 10% of their revenues in domestic

market. For these companies, we would expect a lighter domestic risk exposure. All the same, developed market companies with large revenues from risky emerging markets face more risk than their peers. Nestle, Casino Group and Coca-Cola, for instance, are developed market companies that have significant revenue from Asia

and Latin America. For these companies, there is an additional risk exposure from emerging market countries.

10

b) Corporate governance issues

Emerging market companies are often more exposed to corporate governance issues. Stock-holders often have little control over management and this can be for

different reasons :

• Firms frequently issue two classes of shares: voting and non-voting shares. • Creditor rights are often strong to the detriment of shareholders.

• Poor information disclosure from management that can hide bad news or release it only slowly.

As Bae, Lim and Wei (2006) argue: if a company operates with little transparency to

its outside investors, insiders will be likely to release bad news only when forced to by hard circumstances. The release will thus result in large stock price declines.

Furthermore, with opaqueness, insiders may be tempted to skim the company’s cash flows when times are good and reduce skimming when times are bad. Insiders, therefore, absorb more of a company’s specific risk. As a result, in countries where company information is opaque, the primary driver of stock returns is systematic risk. Finally when there is little or no control over management, the only choice investors have when a firm is run badly is to sell their shares.

c) Cross-holding issues

Many large emerging market companies are cross-holdings. As Damodaran (2014) explains, this is often by design as they used to be old family-controlled firms. In

effect, because these companies didn’t have access to capital markets, they would use capital from other companies of the group. This can be observed when looking at family conglomerates: the firm that has the less cross-holding is usually the most recent one because it no longer needed internal capital thanks to capital markets.

Cross-holdings can have several negative consequences. First, company shares are owned by another company that exerts control leading to governance issues. Second it is difficult to estimate a value given the complex structures. And third, as Damodaran explains (2014) firms may have leverage ratios that appear to be non

11

optimal. Indeed in a group of firms belonging to a holding, some firms can be

overleveraged and others underleveraged because lenders see the entity as a whole. Even though, it is not explicitely said, lenders in fact assume that there is debt capacity transfer between firms of the same-cross holding.

d) Currency volatility

Emerging markets often have high inflation rates. This has to be taken into account as cost of capital can change significantly from one currency to another leading to mistakes in valuation.

e) Lack of comparables

For relative valuation: since emerging markets are smaller, when valuing a company using relative valuation it is harder to get samples of comparables in the same industry and region that are big enough. Though other methods such as DCF can give a value to the company, relative valuation has the benefit of indicating whether a firm is expensive or cheap compared to its peers. One can argue that comparables can be found in developed markets as well, which is true but fundamentals such as risk and growth vary significantly between emerging market companies and developed market companies. Thus values computed can be misleading unless adjustments are done.

IV/ Current methods of valuation With investments turning towards emerging markets, valuation techniques have been

developped by analysts. Since these techniques are relatively new, they often rely on different assumptions or take assumptions into account in different ways. A survey by Pereiro on the Practice of Investment Valuation in Emerging Markets (2006) has studied which methods investors were using and how they were adjusting these methods when

12

investing in Emerging Markets. According to the survey, the most commonly used

methods were the DCF followed by multiples.

1/ DCF adjustments by practitioners

a) Adjusting the cash flows Some analysts build into the expected cashflows the possibility and consequences of bad outcomes. Indeed this computes an expected value across multiple

scenarios, which in some sort, is just a more accurate expected value. Indeed one still needs to discount the expected value for the additional risk he is willing to take by investing in emerging market stocks. Some argue that country risk is diversifiable through global diversification (McKinsey, 2001). Thus as long as it has been incorporated in the cash flows (through probability weighted scenarios) and since only systematic risk is rewarded, there should be no discount rate for such risk. However studies have shown that country risk has become systematic as correlation between stocks from different markets has significantly increased. An example that illustrates that positive correlation is a study by the IMF (2013) showing the financial exposure of advanced economies to emerging economies and vice versa. Thus there must be a discount rate for country risk added.

13

b) Adjusting the discount rate

Other analysts adjust the discount rate by adapting the CAPM technique2 : Before reviewing the CAPM adjusments made by practictioners, let’s begin by

assessing how country risk is measured. Indeed, though adjustment methods for

the cost of capital are numerous, there are only 2 main methods suggested by literature to estimate country risk.

i) Using the default spread based on agency ratings

Moody’s and S&P’s offer sovereign ratings default spreads. Default spreads can be used as measures of country risk for emerging markets because they indicate how much riskier it is to invest in these countries’ bonds compared to those of developed countries. However default spreads are for a country’s bonds which are less volatile than its stocks. Therefore we have to scale the default spread to the country’s stocks’ volatility to obtain the country risk. Thus : Country risk premium = Default spread country’s 10 yr bonds * (Standard deviation in country’s equities / Standard deviation in country’s bond price)

ii) Using the Credit Default Swap rates

CDS are insurance for default and are priced in basis point on the CDS market. They basically indicate default spreads since they represent how much basis points you have to add/pay to overcome the default risk when subscribing to a country’s bonds. However, unlike sovereign default spreads, CDS comprehend a part of « profit » that you have to remove in order to compute the country risk. Indeed when you look at the CDS rate offered for US treasury bonds, it is different from zero (0,46%), although these bonds are risk-free. Thus you can substract the US bonds CDS rate from the CDS you are interested in to get a « synthetic » default spread. Finally to compute the

2 Cost of capital = rf + β (rm-rf) Where rf is the risk-free rate, β is the beta of the security and rm the expected market return

14

country risk, you scale that default spread to the country’s stocks volatility as seen earlier : Country risk premium = (CDS Country bonds – CDS US bonds) * (Standard deviation in country’s equities / Standard deviation in country’s bond price).

iii) How practitionners adjust cost of capital for emerging markets

Once the country risk is obtained, we can compute the Cost of capital using the

CAPM. The following methods are the most commonly used by practitioners when investing in emerging markets according to Pereiro (2006) and Damodaran (2009). We have represented each method on a graph to illustrate the different components taken into account. Thus this indicates how risk is perceived and highlights the potentiel mistakes investors make when computing a discount rate for their DCF valuation.

*For the following part : MRP stands for market risk premium, CRP for country risk premium, RF for risk free, Rm for expected market return and STD for Standard Deviation.

The simplest assumption to make when dealing with country risk is to assume that all

companies in the same country are equally exposed to country risk. This is

MRP$

mature$

market$

RF$

CRP$

×$β$

10$yr$US$bond$yield$

CDSlocal

*(STDEq$$local$

/$STDBd$local

)$

OR$

RaFngHbased$default$spread*(STDEq$$local$

/$STDBd$local

)$

$$Rm

mature$market$

COST$OF$CAPITALUSD

$

FIRM%CAN%BE%OVER%OR%%UNDER/EXPOSED%TO%COUNTRY%RISK!%

Fixed%country%risk%premium%COST$OF$CAPITAL

USD=$rf

US$BOND$+$β×MRP

mature$market$+$CRP$$

15

oversimplifying because exposure depends on factors such as revenues or production

facilities implanted in the country and these factors differ from one firm to another.

Assuming that both the country risk exposure can be reflected by the beta is oversimplifying as well since the beta measures overal macroeconomic risk and not just country risk.

Here the only difference with the fixed country risk premium model is that the market risk premium used is the local one. However this implies some major issues.

MRP$

mature$

market$

RF$

CRP$

×$β$


CDSlocal

*(STDEq$$local$

/$STDBd$local

)$

OR$

RaFngHbased$default$spread*(STDEq$$local$

/$STDBd$local

)$

$$Rm

mature$market$

EXPOSURE(TO(MACROECONOMIC(RISK(MEASURED(BY(BETA((MIGHT(NOT(BE(THE(SAME(AS(EXPOSURE(TO(COUNTRY(RISK!(

COST$OF$CAPITALUSD

$$

Propor9onal(CRP(COST$OF$CAPITAL

USD=$rf

US$BOND$+$β$×$(MRP

mature$market+CRP)$$

DOUBLE'COUNTING!'10#yr#Local#USD#bond#yield#

10#yr#US#bond#yield#

MRP#local#

RF#

CRP#Rmmature#market#

Rmlocal#CDSlocal*(STDEq##local#/#STDBd#local)#OR#

RaEngGbased#default#spread*(STDEq##local#/#STDBd#local)###

CRP#

=#×#β#

Local2CAPM'model'COST#OF#CAPITALUSD=#rfUS#BOND#+#β×MRPlocal#+#CRP##

16

First, as said earlier, it is oversimplifying to assume that all firms in a country are

exposed to the same country risk. Second, local market risk premium already incorporates a part of the country risk premium. Why is that ? Suppose you compare the local market risk premium to a

mature market risk premium. Usually the local market risk premium is higher because the extra riskiness between equity investments and bond investments in emerging

markets is superior to the extra riskiness between equity investments and bond investments in mature markets : in other words, in emerging markets, it is way riskier to invest in equity than in bonds. In mature markets, it is just riskier. Thus using the local market risk premium results in double–counting.

Third, local market risk premiums in emerging markets are difficult to estimate as there is less historical data and the market is less liquid. If the market risk premium were easily computable, we would just have to add the local bond yield (directly avaiblable) to

get the cost of capital that would already include the country risk premium.

As Pereiro (2006) suggests, to avoid double counting, the amount of risk due to country risk can be withdrawn from the local market risk premium. That amount could be

estimated by doing a regression on returns of the firm versus variations of the country risk. Moreover, that will solve the problem of firms being all equally exposed to country risk because regression is made on the returns of one specific firm.

CDSlocal*(STDEq--local-/-STDBd-local)-OR-Ra4ng7based-default-spread*(STDEq--local-/-STDBd-local)---

10-yr-Local-USD-bond-yield-

10-yr-US-bond-yield-

MRP-local-

RF-

CRP-Rmmature-market-

Rmlocal-

×-β-×-(17R2)-NO#MORE#DOUBLE#COUNTING!#

Adjusted#Local;CAPM#model#COST-OF-CAPITALUSD=-rfUS-BOND-+-β×MRPlocal-×(17R2)-+-CRP--

R2-=-amount-of-variance-in-equity-vola4lity-due-to-country-risk--

17

However country risk can only be computed using the CDS rates or the agency ratings

of sovereign bonds. In both case, the sample needed for the regression is too little to be precise because CDS rates and agency ratings aren’t updated frequently enough, thus neither are the country risk premiums.

In the Goldman-Sachs model developped by Mariscal and Hargis (1999), R is the correlation between local stocks and local bonds. In other words, it is the part of volatility of local stocks due to volatility of local bonds. Yet volatily of local bonds is directly linked to the sovereign default spread. Thus it is directly linked to the country risk. Thus R is the part of volatility of local stocks due to country risk. Finally, removing

that part avoids double counting. How to compute R is another story… At the same time, the authors multiply the US market risk premium by (θL / θUS) to reflect the extra riskiness of the local market: one can argue that this time there is double

counting since country risk is supposed to include that already. Finally they include an idiosyncratic risk premium to cope with the fact that idiosyncratic risk is not completely diversifiable in emerging markets, which is comprehensible given their small size.

MRP$US$

market$

RF$

CRP$

×$β$×$(θL$/$θUS)$×$(17R)$$


CDSlocal*(STDEq$$local$/$STDBd$local)$OR$

RaHng7based$default$spread*(STDEq$$local$/$STDBd$local)$$$ RmUS$market$

Rid$

θL$:$Std$of$local$market$returns$$θUS$:$Std$of$US$market$returns$R$:$correlaHon$of$returns$between$local$stock$market$and$$sovereign$bond$used$to$measure$CRP$Rid$:$idiosyncraHc$risk$premium$specific$to$valued$firm$

Goldman(Sachs-model-COST$OF$CAPITALUSD=$rfUS$BOND$+$β$×$MRPUS$MARKET$×$(θL$/$θUS)$×$(17R)$+$CRP$$

18

While all the other methods let the country risk exposure fixed or at least proportional to the mature market risk, this model measures directly the company’s exposure to country risk : similarly to the beta that measures exposure to macroeconomic risk, here, an additional lambda measures exposure to country risk. As Damodaran (2009) explains, in order to measure exposure, there are 2 methods : The first one is to use as a proxy : the ratio of revenues that your company derives from a country divided by the average revenues of a company from that country. This would tell you how linked to the local economy the company is compared to its peers. The second method is to do a regression on the stock price versus the local bond price. Indeed bond price is a good indicator of country risk. When country risk decreases, bonds go up in price. Therefore if the company’s stocks move very much like bonds (λ = 1), the company is very exposed to country risk.

To conclude, in this model estimates are easy to compute and it seems that there is no double counting risk. Moreover, it takes into account the fact that all firms in emerging

markets are not equally exposed to country risk.

MRP$mature$market$

RF$

CRP$ ×$λ$

×$β$10$yr$US$bond$yield$

CDSlocal*(STDEq$$local$/$STDBd$local)$OR$RaGngIbased$default$spread*(STDEq$$local$/$STDBd$local)$$$ Rmmature$market$

COST$OF$CAPITALUSD$

Damodaran(single.factor(model(COST$OF$CAPITALUSD=$rfUS$BOND$+$β×MRPmature$market$+$λ×CRP$$

19

Finally the Damodaran multi-factor model builds on the same assumptions but is even

more accurate. Indeed it takes into account the exposure to country risk but also the fact that some emerging market companies can have their business spread over

several emerging countries. Suppose our lambdas are exact, then this model seems to be both pragmatic and precise.

iv) Dealing with currency issues In DCF valuation, currency switches can have a big impact, especially when they are not done consistently. Indeed the choice of currency for the cash flows determines the choice of currency for the cost of capital. For instance cash flows in US Dollars requires a cost of capital in US Dollar terms (meaning a cost of capital that is composed of a US treasury bond yield and a US market risk premium). As Damodaran (2009) explains, as long as the discount rate and the cash flows go along, valuation can be done in any

currency. Moreover it is possible to switch currency as long as you take inflation into

account (see Guideline part for more details).

v) Adjusting for bad corporate governance When facing bad corporate governance and low performance, one can be tempted to

include an additional discount rate to reflect bad decisions from management. However this can lead to over discounting. Indeed bad corporate governance is reflected in valuation if all the assumptions are

taken into account rigorously. For instance, a firm that has a non optimal debt ratio due

CDSlocal*(STDEq--local-/-STDBd-local)-for-each-country-OR-

Ra<ng>based-default-spread*(STDEq--local-/-STDBd-local)--for-each-country-

MRP-mature-market-

RF-

CRP-Country-3-

×-λcountry-1-×-weight-of-revenues-in-country-1--

×-β-

10-yr-US-bond-yield-

Rmmature-market-

CRP-Country-2-

CRP-Country-1-

×-λcountry-2-×-weight-of-revenues-in-country-2---

×-λcountry-3-×-weight-of-revenues-in-country-3--

Damodaran(mul+,factor(model(COST-OF-CAPITALUSD=-rfUS-BOND-+-β×MRPmature-market-+-Σ-λi-×-CRPi-×-wi-

20

to management’s poor financial performance will suffer from a high WACC. The high

WACC must be kept as long as management remains. Thus its value will be reduced. All the same, a firm that makes bad investment decisions will see its value decrease. For instance, let us assume that a firm has a WACC of 15% and invests in projects that have a 10% Return on capital. Since Expected growth = Reinvestment rate * Return on

capital (for FCFF valuations), growth will automatically decline, decreasing its value.

2/ Relative valuation in emerging markets As Pereiro observed (2006), the problem of relative valuation in ermerging markets is

that there are very few comparable companies. Analysts often find alternative comparables in developed markets. However firms in emerging countries and developed coutries not only differ in terms of fundamentals such as risk and growth, they also have different accounting standards. Thus analysts have to make cross-border corrections whenever they resort to relative valuation.

V/ A practical guideline for valuation of emerging market companies

1/ Some useful facts about DCF methods In view of offer ing a practical guidel ine for valuation, we found it useful to

start by reminding some essential aspects of DCF methods. I f one is already famil iar with these concepts, we recommand to fol low on with the

adjustment methods for emerging markets in the next part.

21

All DCF methods rely on pretty much the same principle, a value of a firm today is the

present value of its future cash flows. However, when looking into details, there are many versions of DCF. Therefore, to know which version to use, one way is to ask the following questions :

As valuation can be done from different perspectives, one must consider which method (direct or indirect) and which cash flows are appropriate according to his point of view as an investor. Depending on the type of cash flows taken into account, you will either value equity directly or estimate enterprise value first to get to value equity. There are 3 types of cash flows :

• Free Cash Flows to the Firm • Free Cash Flows to Equity • Free Cash Flows to Shareholders.

Capitals engaged generate FCFF which are purely economic. FCFE are cash flows left after debt services. They belong to shareholders but these don’t actually earn FCFE.

Instead they earn FCFS which are basically Equity Services (dividends and buy backs). Depending on who you are as an investor and what your incentives are, you need to

choose a specific type of cash flows to value the company.

What type o f investor ? I. Direct valuation (V as Equity and

FCF as FCFE or FCFS)

II. Indirect valuation (V as Enterprise Value and FCF as FCFF)

Which scenario ?

1. Stable growth model 2. Two-Stage model

3. Three-Stage model 4. Cash Flow Fade

Which r isk ? a. WACC

b. ke

22

a) As a minority shareholder As a minority shareholder, the only cash flows you receive are dividends and buy backs. Some particularities of dividends to keep in mind are :

• They are smoothed even when earnings are volatile.

• Firms often have a specific dividend policy. They can pay out less to stockholders than they have available cash flows to equity. Thus they are using the difference to

increase their cash balance or to invest in marketable securities. The implication is when using the Dividend Discount Model is that it won’t take into account the buildup of cash that occurs when firms pay out less than they can afford. The value of equity can therefore be underestimated.

There are some main reasons why firms pay out less than is available :

• Firms are generally very reluctant to changing dividends. This because they are uncertain about future earnings and about whether they could keep up distributing the same level of dividends if they decide to increase it. Because firms often use dividends as signals of future prospects, decreasing dividends is seen as negative signals.

• Rather then issueing stocks which is expensive (due to floatation costs and issuance fees), they can choose to keep the excess cash for future financing needs.

• Management may try to retain cash to build cash cushions to obscure earning drops in bad periods to remain in control.

• Firms may prefer to generate financing internally.

• If tax rates induce investors to favor capital gains over dividends, investors can pressure management to reinvest rather than pay out earnings.

• Retained earnings can be preferred as a source of capital if alternative sources of capital are scarce, which is tied closely to the level of domestic capital market development.

A framework to assess dividend policy has been developped by Damodaran (2013). By locating the firm valued on the framework would help you project upcoming dividends.

23

b) As a controlling stockholder

Even with buy backs, some firms fail to return to their stockholders and others pay more than what they can afford to. When it’s one of these cases, looking at FCFE may give more visibility. FCFE are cash flows left over after meeting all financial obligations such as debt payments after covering capital expenditures and working capital needs. Thus they are basically all the cash available for stockholders. FCFE = Net income – equity reinvestment

= Net income - (Capital expenditures – Depreciation) – Change in noncash working capital + (New debt issued – Debt repayments)

Sometimes, dividends can exceed FCFE and therefore yield a higher value then FCFE. In that case, it is best to go with the FCFE model because the dividends are not

sustainable. But most of the time, the value from the FCFE model will exceed the value

from the Dividend Discount Model. The difference between the two values can be considered one component of the value of controlling the firm which is the control of dividend policy.

Quality of projects taken: ROE versus Cost of EquityPoor projects Good projects

Cash Surplus + Good ProjectsMaximum flexibility in setting dividend policy

Cash Surplus + Poor ProjectsSignificant pressure to pay out more to stockholders as dividends or stock buybacks

Cash Deficit + Good ProjectsReduce cash payout, if any, to stockholders

Cash Deficit + Poor ProjectsCut out dividends but real problem is in investment policy.

24

c) As a strategic investor The FCFF is the sum of the cash flows to all claim holders in the firms, including common stockholders, bondholders and preferred stockholders. If a firm is expected to change its capital structure in the future in an unpredictable or complex way, then FCFF

is a better approach.

FCFF = FCFE + Interest expense (1 – Tax rate) + Principal repayments – New debt issues + Preferred dividends = EBIT (1 – Tax rate) + Depreciation – Capital expenditure – Change in Working capital

d) Summarizing the three models

2/ A practical approach to adapt DCF methods for emerging markets

a) Consistency in currencies Valuation can be done in the local currency or in US Dollars as long as the cash flows

projected and the discount rate are in the same currency. If however it is difficult to

estimate the cash flows and the discount rate directly in the same currency, the following table helps you keep track when doing the currency switches.

DCF MODEL Formula Discount rate Growth estimate To get to equity value

Dividend Discount ModelDividends + Buy backs ke Operating assets

Cash and marketable securities

Retention ratio = (1-payout) g = Retention ratio * ROE

Cash and marketable securities already built into earningsNothing to add

FCFE ModelNet income - (Capital expenditures – Depr.) – Δnoncash WC + (New debt issued – debt repayments)

ke Operating assets Equity reinvestment rate = (CapEx - Depreciation + Δnon-cash WC - Net debt issues) / Net income

g = Equity reinvestment rate * ROE

Add cash and marketable securities

FCFF ModelEBIT(1-tax) + Depr. - Capex - ΔWC WACC Operating assets Reinvestment rate = (CapEx - Depreciation + ΔPV

of leases + Δnon-cash WC) / EBIT(1-t)g = Reinvestment rate * ROC

Add cash and remove debt

Reinvestment

25

Accounting for differential inflation in the cost of capital when switching currency:

Cost of capital in local currency = (1 + Cost of capital in USD) * (1 + Exp inflation local currency) / (1 + Exp inflation USD) – 1 Accounting for differential inflation in the growth rate when switching currency: Stable growth rate = (1 + Stable growth rate in USD) * (1 + Exp inflation local currency) / (1 + Exp inflation USD) – 1

b) Estimating a cost of capital using the Damodaran approach Having reviewed the popular methods used by practitioners, we have chosen to focus

on the Damodaran model because of its clarity and above all because of its practical

aspect.

Estimating exposure to country risk : the lambda approach

As discussed earlier it is necessary to estimate a parameter very similar in terms of mechanism to the beta to measure the company’s exposure to country risk : the

lambda. Expected Return = Rf + Beta (Mature Market Equity Risk Premium) + λ (Country Risk

Premium)

26

How to estimate the Lambda. Before estimating the lambda, we begin by discussing the three main factors behind country risk exposure :

• Revenue source : The most impacting factor is the company’s source of

revenue. An emerging market company whose revenues come mostly from developed countries won’t have the same exposure to country risk as a

company whose business is mostly local. If a firm has revenues deriving from several emerging countries with different risk premiums, one should consider using the multi-lambda approach.

• Production facilities : A company having most of its production facilities in emerging markets is highly exposed to country risk as any economic changes can have an important impact on production and therefore affect profits.

• Risk management products : Some companies can use risk management products such as insurance against contingencies or derivatives. Using such products can lower significantly the company’s exposure to country risks.

There are 2 ways to measure the lambda

! The first and simplest is to base risk exposure entirely upon revenues with the

main advantage being that information is easily accessible. Given that the average lambda across all stocks has to be one (similarly to the average beta of an index), we cannot simply use the percentage of revenues that a company

gets from a market as lambda. It is therefore necessary to scale this measure by dividing it by the part of revenues an average company derives from the local market.

λ = % Revenue in country (company) / % Revenue in country (average company

in market)

27

! The second measures how they move in relation to movements in country risk.

Bonds issued by countries offer a simple and updated measure of country risk; as investor assessments of country risk become more optimistic, bonds issued by that country go up in price, just as they go down when investors become more pessimistic. A regression of the returns on a stock against the returns on a

country bond should therefore yield a measure of lambda in the slope coefficient.

Return (stock) = a + λ * Return (Country bond)

c) Estimating the cost of debt for emerging market companies If you want the WACC for your valuation, you would need to compute the cost of debt

as well. Since bonds are riskier in ermerging markets, you would need to add to the risk-free rate, a default spread for the country as well as a default spread for the company. While default spreads are easy to get a hold on (Moody’s and S&P’s deliver credit ratings translated into spreads), you might have to compute a synthetic rating. To make this assessment, we begin with rated firms and examine the financial characteristics shared by firms within each ratings class. The following table lists the range of interest coverages for firms under $5 billion in market cap in each S&P ratings class.

d) Accounting for one-sided risks

28

Country risk incorporates most of issues specific to ermerging markets however it does

not account for one-time isolated events with an important impact on the value of the company. Kennedy (2002) call these one-sided risks because of their asymmetrical nature. These include the possibility of expropriation (a downside risk) and the possibility of attractive follow-on investments (an upside variance). As discussed earlier, building in

the cash flows weighted scenarios does not incorporate the risk, it only gives a more accurate value of the expected return. Indeed, to really include such risks, Damodaran

(2009) recommands adding probability weighted scenarios but not directly in the cash flows. Instead the company needs to be valued as if the event would never occur and a second time with the event occuring. Thus country risk will be appropriately included in both valuations. Finally the value of the company is obtained by weighting both values

with the corresponding probability. In effect, such risk are often already incoporated by the markets. A type of company that illustrates inclusion of one-sided risks are chrony capitalist companies. These

usually trade with a 40% discount because the markets consider that such firms have a risk of being nationalized.

3/ A practical approach to adapting relative valuation for emerging markets

Though DCF methods give an accurate value of the firm, it is recommanded to establish

a relative valuation of the firm as well. Indeed relative valuation can be done more easily since it requires less inputs and forecasting. Moreover, relative valuation lets you know if a company is expensive or cheap compared to market standards. However it faces two

major issues in Emerging Markets : ! First, available comparables can be scarce and even scarcer if they have to be in

the same business and in the same emerging market.

! Second, firms can have significant differences on fundamentals (risk, cash flows and growth) and these differences increase when you use comparables from different markets (for instance using comparables in a developped market when

29

comparables are missing in the Emerging Market). Therefore it is necessary to

take measures to mitigate these issues. The following suggestions are techniques to mitigate issues faced doing relative valuation of emerging market companies.

a) To increase size sample i) Instead of looking for companies in the exact same business, it is possible to

look for comparables whithin the economic chain of that business. For instance when looking for a comparable of an auto company, both auto parts

manufacturers and auto distributors are eligible. ii) It is possible to expand the sample geographically to other Emerging Markets.

Thus, for example, when analysing a firm in Thailand, you can use comparables in the South-Est Asia area.

b) To mitigate difference in fundamentals i) Scale to variables that are less affected by discretionary choices.

For instance, multiples of revenues (which are more difficult to manipulate) should be preferred to multiples of earnings. We can also scale value to units specific to the business being valued – the value of steel companies can be compared based on market value per ton of steel produced, and the value of electricity generators can be computed on the basis of kilowatt hour of power produced.

ii) Value businesses, not equity. Similarly to DCF methods seen earlier, there are in relative valuation direct multiples which are equity multiples (where equity value is scaled to equity earnings or book value) and indirect multiples which are enterprise value

multiples (where the value of the business is scaled to operating earnings, cash flows or the book value of capital). Popular direct multiples include : Price-

Earning Ratio, Price-Cash Flow Ratio, Price-Book Ratio and Price-FCFE ratio.

30

And popular indirect multiples are the following : EV-EBITDA Ratio, EV-FCFF

Ratio, Tobin’s Q, EV-Sector Specific Fundamental Ratio. Given the wide differences in equity claims and the use of debt across businesses, it is better to focus on enterprise value multiples rather than equity

multiples. In other words, it is better to value the entire business and then work out the value of equity than it is to value equity directly.

VI/ Valuation of Vinamilk To illustrate the different methods we suggested, we applied them to the valuation of an emerging market company, Vinamilk. Again, during this valuation we aimed to get estimates through practical methods.

1/ Brief presentation of Vinamilk

Vinamilk is a Vietnamese manufacturer of dairy products. It is the second largest Vietnamese private firm in terms of market capitalization (USD 5,3 billion at the end of 2013).

In 2013, it derived 86% of its revenue from the Vietnamese market. Indeed around 80%

of Vietnam’s GDP comes from export, therefore we can assume that the average Vietnamese company derives 20% of its revenue from the Vietnamese market. By generating 4 times more in terms of revenue weight from the Vietnamese market,

Vinamilk is without doubt more exposed to country risk than the average Vietnamese company.

Vinamilk has been growing significantly in the last 4 years and it is still putting a lot of efforts to maintain that growth.

31

Source : 2013 Annual Report

In the valuation, I made an assumption of high growth for the next 5 years before reaching a more sustainable growth rate after year 5. Moreover, Vinamilk is focusing on expanding its revenue from export. Thus we can assume that it will be less exposed to country risk after year 5. Finally, as Vietnam is going through a high development phase, having become increasingly open in recent years and growing at nearly 6% (see graph below), I assumed that country risk will decrease as well after year 5.

A quick outlook on Vietnam’s impressive growth

32

2/ Estimating Vinamilk’s Cost of capital First, it is important to choose a currency for the valuation and to be consistent thereafter. We can either value Vinamilk in US Dollars by converting cash flows to US Dollars with an exchange rate of today, adjusted by differential inflation between the US and Vietnam. But then we have to make sure that the cost of capital is in US Dollar

terms as well (meaning that it incorporates a US risk-free rate adjusted by a US market risk premium and finally a country risk premium for Vietnam).

Or we can value Vinamilk in Vietnam Dong (VND) by using cash flows in VND. However the cost of capital in VND is hard to compute. It is relatively easy to have VND risk-free rate : we can use the Vietnamese 10-year government bond to compute a risk-free rate by substracting the default premium from the bond’s yield. This default premium can be estimated with Vietnam’s rating by agencies such as Moody’s and Standard&Poor’s

(B2 by Moody’s, Ba2 by Standard&Poor’s). But the market-risk premium from the Vietnamese Market is hard to estimate and imprecise due to lack of historical data and lack of liquidity.

Thus we compute a cost of capital in US Dollar terms then convert it to VND by using the differential inflation between the US and Vietnam :

33

Cost of capital in VND = (1+Cost of capital in USD) * (1+Exp inflation in VND) / (1+Exp inflation in USD) - 1 To estimate the cost of capital in US dollar terms, we start with the US 10-year treasury

bond rate of 2,59%. The equity risk premium that we are using for mature markets (like the US) is 5%.

To estimate the country risk premium for Vietnam, we can either :

1) Use the default spread estimated with Vietnam’s Sovereign rating by agencies as

the country risk premium. (Or)

2) Use the Credit Default Swap market to estimate cost of insurance for default of the Vietnamese Government.

34

We can notice that the CDS rate for US 10-year treasury bonds is different from zero even though they are risk-free. Thus we have to withdraw from Vietnam’s 10-year CDS rate the US 10-year CDS rate => Default spread for Vietnam = 3,35% - 0,46% = 2,89%

However, since the default spread is to assess sovereign bonds, we have to include the

higher volatility between bonds investments and equity investments in Vietnam. Here below we can see that it’s 2,01 times riskier to invest in stocks than in bonds in Vietnam.

1) => Using the Sovereign rat ings : Country r isk premium for Vietnam = 5,50% * 2,01 = 11,05% 2) = > Using the CDS rates : Country r isk premium for Vietnam = (3,35% - 0,46%) * 2,01 = 5,81% For the following part we will retain the country risk premium given by the CDS market. Indeed default spread given by rating agencies can sometimes lack precision. For instance, if we take the case of India :

• its rating is Baaa3 which corresponds to a default spread of 2,20%.

• India has Std deviation in Equities/Std deviation in Bond price of 2,48 (it is 2,48 times risquier to invest in Stocks than in Bonds in India).

• Thus 2,20% * 2,48 = 5,47% for the country risk premium which is almost two times less than Vietnam.

• In the meantime the CDS rate offered for India is 3,51%. If we subtract 0,46% (CDS rate for the US) and multiply by 2,48 : (3,51% - 0,46%) * 2,48 = 7,56% which, this time, gives a country risk premium superior to Vietnam !

35

With a beta of 0,52 (regressed against the Vietnam Stock Index), we have obtained the

following information :

To obtain the Cost of capital, we now have to estimate Vinamilk’s exposure to country-risk (Lambda) as : Cost of Capital = Risk-free rate + Beta * Market risk premium + Lambda * Country risk premium.

As seen earlier, we can estimate Lambda using either revenue or returns of Vinamilk stocks regressed against returns of Vietnamese sovereign bonds:

1) Revenue-based approach : since we don’t have the average domestic revenue of a Vietnamese company, we estimated it : If we assume that the part of Vietnam’s GDP deriving from export (80%) leads to the average revenue made by Vietnamese companies through export (thus 80%), this means that the average Vietnamese company derives 20% of revenue

sfrom the domestic market. Vinamilk with 86% of revenue coming from Vietnam would be deriving 4,3 times more than the average Vietnamese company. Thus it would have a Lambda of

4,3 !

2) Price-based approach : regressing the weekly returns on Vinamilk stocks between May 2011 and May 2014, vs the Vietnamese government bonds yields of the same period yields a lambda of 1,908:

36

We use the latter to compute a USD cost of capital for Vinamilk as it seems more realistic:

USD Cost of capital of Vinamilk = 2,59% + 0,52 * 5% + 1,98 * 5,81% = 16,70%

To get the VND Cost of capital since we are projecting cash flows in VND :

" VND Cost of capital of Vinamilk = (1+USD Cost of capital) * (1+Exp inflation VND) / (1+Exp inflation USD) – 1

= (1 + 16,70%) * (1 + 6%) / (1 + 2%) – 1 = 21,27%

37

2/ Estimating Vinamilk’s Cost of debt To estimate the USD cost of debt for Vinamilk, we need to determine 3 variables :

1. The risk free rate : given by the US 10-year treasury bond, 2,56%. 2. The default risk of Vietnam : given by the CDS market. The default spread on 10-

year Vietnamese bonds is equal to 3,35% - 0,46% = 2,89% (CDS rate for Vietnam – CDS rate for the US).

3. The default risk of Vinamilk : since Vinamilk doesn’t have bonds outstanding that it trades on a regular basis, it is not rated. We can however estimate a synthetic rating based on its interest coverage ratio. There are listings available that link the interest coverage ratio, the rating and the default spread.

If we look at the interest coverage ratio for Vinamilk, using the 2012 income statement :

Interest coverage ratio = Operating income/Interest expenses = 6930/3 = 2225

With such a large interest coverage ratio, Vinamilk has the minimum default spread of 0,40%.

38

Finally summing up these 3 variables we obtain a cost of debt of 5,88% : USD Cost of debt = Risk-free rate + Default spread Vietnam + Default spread Vinamilk

= 2,56% + 2,89% + 0,40% = 5,88%

Again we have to switch currency using differential inflation since our cash flows are in

VND : " VND Cost of debt of Vinamilk = (1+USD Cost of debt) * (1+Exp inflation VND) /

(1+Exp inflation USD) – 1 = (1 + 5,88%) * (1 + 6%) / (1 + 2%) – 1 = 10,03%

WACC

Using the debt ratio and the tax rate from the 2013 Annual Report, we compute the WACC :

WACC = 77% * Cost of capital + 23% * (1 – Tax rate) * Cost of debt = 77% * 21,27% + 23% * (1 – 25%) * 10,03% = 18,08%

3/ Estimating Vinamilk’s Growth rate

In the 2013 Annual Report, Vinamilk reported an operating income of VND 8 010 billion, after depreciating VND 756 billion. During the year, acquisitions and internal

39

investments combined to create capital expenditure of VND 1 440 billion.

However the Capital expenditure budget was not consumed entirely in 2013 and the « budget not yet fulfilled in 2013 will be transferred for disbursement in 2014 » (quote : 2013 Annual Report). Thus capital expenditures amount to VND 3 758 billion for 2014 (budget non consumed in 2013 + budget 2013). In 2013 Vinamilk’s non-cash working capital decreased by VND 79 billion and the present value of its leases increased by VND 48 billion. We can therefore compute a reinvestment rate : Reinvestment rate = (Capex–Depreciation+Change in non-cash working capital+Change in PV of leases) / EBIT(1–tax rate) = (3758–756-79) / 8010(1–25%) = 28% Based on the start-of-the-year book value of equity -VND 15 493 billion-, the start-of-the-year book value of debt –VND 4 205 billion- and the start-of-the-year cash balance –VND 1 252 billion-, we can compute the Return on capital :

Return on capital = EBIT (1–Tax rate) / (BV of equity+BV of debt–Cash balance)

= 33%

Combining both and assuming that it is going to reinvest at the same rate for the next 5 years, we get the expected growth rate for the next 5 years:

40

Expected growth rate = Reinvestment rate * Return on capital

= 28% * 33% = 8,97%

4/ Terminal value

After 5 years, we assume that Vinamilk is going back to a more sustainable growth rate of 5% (which is a little inferior to the Vietnamese economy’s today growth rate). We

assume that country risk premium would have decreased to 5% by then. Moreover as Vinamilk is focusing on expending its revenue part in export, we believe that its exposure to country risk will decrease as well, resulting in a lambda of 1,5 instead of 1,9 after year 5.

5/ Value per share We then forecast the FCFF, based on it’s 2013 operating profit of VND 8 010 billion and get a value of operating assets –or Entreprise value- of VND 105 305 bi l l ion.

We substract from the Enterprise value the book value of debt –VND 5 307 billion- assuming that market value and and book value of debt are very similar (Vinamilk is not trading obligations). We then add the cash balance of VND 1 252 billion and get a value of Equity of VND

101 250 billion. Dividing by the number of shares outstanding, we find a value per share of VND 121 481.

Year 1 2 3 4 5EBIT(1't) 8+728 +++++++++++++++++++ 9+511 +++++++++++++++++++ 10+364 ++++++++++++++++ 11+294 ++++++++++++++++ 12+307 ++++++++++++++++Reinvestment 2+404 +++++++++++++++++++ 2+619 +++++++++++++++++++ 2+854 ++++++++++++++++++ 3+110 ++++++++++++++++++ 3+389 ++++++++++++++++++FCFF 6+325 +++++++++++++++++++ 6+892 +++++++++++++++++++ 7+510 ++++++++++++++++++ 8+184 ++++++++++++++++++ 8+918 ++++++++++++++++++Terminal+value 189+079 ++++++++++++++Present+value 5+356 +++++++++++++++++++ 4+943 +++++++++++++++++++ 4+561 ++++++++++++++++++ 4+209 ++++++++++++++++++ 86+236 ++++++++++++++++Value-of-operating-assets-in-Billion-VND 105-305 --------------

41

Vinamilk traded at VND 130 000 per share at the beginning of May 2014, which made it slighly overvalued by the market.

CONCLUSION

Though there are valuation methods that are reliable and practical, these are not widespread. We think there still is room for understanding the risks specific to emerging

markets. As we discussed in the beginning of the paper, emerging markets face challenges that are very typical (ranging from state-intervention to presence of complex cross-holdings) and still value is being estimated thanks to a premium called “country risk” that can sometimes seem blurry. On one hand, emerging markets still lack the tools that let us study exhaustively their underlying sources of value: there are few historical data, markets are still weak in terms of market capitalization and lack liquidity – that is why we chose to focus on practicality-. On the other hand, the tools offered for valuing emerging market companies are still

very new to practitioners and vary significantly. But as attention shifts towards emerging countries and demand for valuation methods grow, we hope that these methods would converge towards a common best practice.

Value&of&equity&in&Billion&VND 101&250 &&&&&&&&&&&&&&Number'of'outstanding'shares 833'467'061 '''''''Value&per&share&in&VND 121&481 &&&&&&&&&&&&&&

42

APPENDICE Vinamilk valuation input sheets

Risk%free%rate%USD 2,59%Market%risk%premium%USD 5,00%Country%risk%premium%USD 5,81%Beta%leveraged 0,52

Average%domestic%revenue%vietnamese%company 20%Domestic%revenue%Vinamilk 86%Lambda%Revenue@based 4,31

Lambda%Price@based 1,98

Cost%of%Capital%USD 16,70%Cost%of%Capital%VND 21,27%Expected%inflation%VND 6%Expected%inflastion%USD 2%

Cost%of%debt%USD 5,88%Cost%of%debt%VND 10,03%Interest%Coverage%Ratio%(EBIT/interest) 2+225 +++++++++++++Default%spread%of%Vinamilk 0,40%Default%spread%Vietnam%(based%on%CDS%market) 2,89%

Equity%(includ.%minority%interest) 17+568 ++++++++++Total%liabilities 5+307 +++++++++++++Debt 23%Equity 77%Tax%rate 25%

WACC 18,08%

Profit%Before%Tax 8+010 +++++++++++++Start@of@the@year%book%value%of%equity 15+493 ++++++++++Book%value%of%debt 4+205 +++++++++++++Cash%balance 1+252 +++++++++++++

CAPEX 3+758 +++++++++++++Depreciation 786 ++++++++++++++++Change%in%PV%of%leases 48 ++++++++++++++++++Change%in%non@cash%working%capital (79)++++++++++++++++

Return%on%capital 33%Reinvestment%rate 28%Expected%Growth%rate%for%the%next%5%years 8,97%

AFTER YEAR 5Stable%growth 4,00%Country%risk%premium 5,00%Lambda 1,50Cost%of%Capital 12,69%WACC 10,77%

43

Operating income / interest expensesFrom To Rating Default1Spread Operating*income*2012 6*930 ******

12,5 100000,0 Aaa/AAA 0.40% Interest*paid*2012 3 *************9,5 12,5 Aa2/AA 0.70% Interest1coverage1ratio 2*225 ******7,5 9,5 A1/A+ 0.85%6,0 7,5 A2/A 1.00%4,5 6,0 A3/AA 1.30%4,0 4,5 Baa2/BBB 2.00%3,5 4,0 Ba1/BB+ 3.00%3,0 3,5 Ba2/BB 4.00%2,5 3,0 B1/B+ 5.50%2,0 2,5 B2/B 6.50%1,5 2,0 B3/BA 7.25%1,3 1,5 Caa/CCC 8.75%0,8 1,2 Ca2/CC 9.50%0,5 0,8 C2/C 10.50%

A100000,0 0,5 D2/D 12.00%Source: Capital IQ

in#Billion#VND 2013 20121"year 10 """"""""""""""""""""""""""""""" 8 """""""""""""""""""""""""""""""""2"to"5"years 41 """"""""""""""""""""""""""""""" 34 """""""""""""""""""""""""""""""More"than"5"years 298 """"""""""""""""""""""""""""" 238 """""""""""""""""""""""""""""

Cost"of"debt 8,49%PV"of"leases 243 """"""""""""""""""""""""""""" 194 """""""""""""""""""""""""""""Change+in+PV+of+leases 48 +++++++++++++++++++++++++++++++

in#Billion#VND 2013 2012Change'in'receivables (38)''''''''''''''''''''''' (178)'''''''''''''''''''''Change'in'inventories 259 '''''''''''''''''''''' (273)'''''''''''''''''''''Change'in'payables (272)''''''''''''''''''''' 269 ''''''''''''''''''''''Change'in'prepayments (28)''''''''''''''''''''''' (18)'''''''''''''''''''''''CHANGE+IN+non/cash+WC (79)+++++++++++++++++++++++ (201)+++++++++++++++++++++

44

BIBLIOGRAPHY Books Berk, J. & P. DeMarzo (2008), Finance d'entreprise, Pearson Education France, Paris. Damodaran, A. (2012), Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, John Wiley & Sons, Hoboken, NJ. Articles Aivazian, V. & L. Booth, S. Cleary (2001), “Do Firms in Emerging Markets Follow Different Dividend Policies From Those in the US: Evidence From Firms in Eight Emerging Countries”, SSHRC, October. Mariscal, J & Hargis, K (1999), « A Long-Term Perspective on Short-Term Risk : Long-Term Discount Rates for Emerging Markets », Goldman Sachs Investment Reasearch, October. Ararat, M. & G. Dallas (2014), “Corporate Governance in Emerging Markets: Why It Matters to Investors—and What They Can Do About It”, International Finance Corporation, April. Conover, M. (2011), “Investment Issues in Emerging Markets: A Review”, The Research Foundation of CFA Institute Literature Review, November. Damodaran, A. (2003), “Measuring Company Exposure to Country Risk: Theory and Practice”, Stern School of Business, September. Damodaran, A. (2007), “Returning Cash to the Owners: Dividend Policy”, Stern School of Business, October. Damodaran, A. (2009), “Volatility Rules: Valuing Emerging Market Companies”, Stern School of Business, June. Damodaran, A. (2009), “Valuing Young, Start-Up and Growth Companies : Estimation Issues and Valuation Challenges”, Stern School of Business, May. Damodaran, A. (2009), “Valuing Distressed and Declining Companies”, Stern School of Business, September. Damodaran, A. (2012), “Equity Risk Premiums (ERP): Determinants, Estimation and Implications”, Stern School of Business, March.

45

Glen, J.D. & Y. Karmokolias, R. Miller, S. Shah (1995), “Dividend Policy and Behavior in Emerging Markets”, International Finance Corporation, N°26, July. Gompers, P. & V. Ivashina, T. Dore (2012), “Private Equity Valuation in Emerging Market”, Harvard Business School, September. International Monetary Fund (2014), “Recovery Strengthens, Remains Uneven”, International Monetary Fund, April James, M. & T.M. Koller (2000), “Valuation in Emerging Markets”, John Wiley & Sons, June. Kennedy, R. (2002), “Project Valuation in Emerging Market”, Harvard Business School, May. MacBeath, A. (2010), “Emerging markets: leading the way to recovery”, Grant Thornton, December. MSCI Barra (2008), “Emerging Markets: a 20-year Perspective”, MSCI Barra, December. Nguyen, D.M. & T.M.H Nguyen, T.T.D. Nguyen, D.T. Nguyen (2010), “Equity Valuation Model of Vietnamese Companies in a Foreign Securities Market – A Simulation Approach.”, National Economics University, September. Solnik, B. & C. Boucrelle, Y. Le Fur (1996), “International Market Correlation and Volatility”, Financial Analysts Journal, September/October. Pereiro, L.E. (2011), “ The Valuation of Closely-Held Companies in Latin America”, Universidad Torcuato di Tella, November. Pereiro, L.E. (2009), “ The Practice of Investment Valuation in Emerging Markets: Evidence from Argentina”, Universidad Torcuato di Tella, May. Vinamilk (2013), “Annual Report 2013”, Vinamilk, December.

Valuation of Firms in Emerging Markets

Economy & Finance

Transcript of Valuation of Firms in Emerging Markets