COUNTRY RISK 2018: A MID-YEAR UPDATE. Aswath Damodaran

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1 COUNTRY RISK 2018: A MID-YEAR UPDATE Aswath Damodaran

2 2 Setting up country risk Aswath Damodaran Investors are more global: Encouraged to spread their bets around the world, investors have shed some of the home bias in their portfolios and added foreign equities to their portfolios. As are companies: Even those that have stayed invested with companies in their own markets are finding that those companies derive large chunks of their revenues from foreign markets. No place to hide: There is no place to hide from assessing global risk and analysts who bury their head in the sand will miss large parts of the big picture. My twice-annual updates: I update my country risk premiums, twice every year, just as I have for the last 25 years. 2

3 3 The Fundamentals of Country Risk Aswath Damodaran The prevalence of corruption in a country, with the corrosive influences it has on business practices and financial reports. Increased exposure to violence from war or terrorism in some countries, creating not just additional operating costs (for insurance and protection) but also the real possibility of a complete loss of the business. The legal system for enforcing property rights, since a share in even the most valuable business in the world is worth little or nothing, if property rights are ignored or violated on a whim. In this section, we will look at the state of the world on these three dimensions. 3

4 1. Corruption: Why we care It is a hidden tax: The effective tax rate that a company pays in a corrupt economy will be much higher than the statutory tax rate. Since it is not legal for companies to pay bribes in much of the developed world, it is not explicitly reported as such in the financial statements but it is a drain on income, nevertheless. 2. It can be a competitive advantage or disadvantage: In many corrupt economies, there are companies that are not only more willing but also more efficient at playing the corruption game, giving them a leg up on businesses that face moral or legal restrictions on playing the game. Aswath Damodaran 4

5 Global Corruption: A Picture 5 Aswath Damodaran 5

6 II. Violence: Why we care.. Protecting the business and its employees against the violence is expensive, with more security built into even the most common place practices. To the extent that this protection is not complete, there is the added cost of the destruction wrought by violence. In extreme cases, the violence can cause a business to fail. It is true that you can insure against some of these events, but that insurance cost will be high and reduce profit margins. 6

7 Violence: Global Picture 7

8 III. Legal Protection: Why we care.. In valuation, we value a business or a share in it, on the assumption that that you are entitled, as the owner, to a share of its assets and cash flows. That is true, though, only if private property rights are respected and are backed up a legal system in a timely fashion. As property rights weaken, the claim on the cash flows and assets also weakens, reducing the assessed value, and in extreme circumstances, such as nationalization with no compensation, the value can converge on zero. 8

9 Legal Protection: Global Picture 9

10 Composite Risk Measures 10

11 Default Risk Sovereign Ratings: Ratings agencies have rated corporate bonds for default risk, using a letter grade system that goes back almost a century. In the last three decades these agencies have turned their attention to sovereign debt, using the same rating system. Sovereign CDS Spreads: Look at what investors are demanding as a spread for buying bonds issued by a risky sovereign. Since there only a few countries where this is the case, it is provident that the sovereign CDS market has expanded over the last decade. This market, where you can buy insurance, on an annual basis, against default risk, has expanded over the last few years and there are now about 80 countries where you can observe the traded spreads. 11

12 Sovereign Ratings: Global Picture 12

13 Sovereign CDS Spreads: Global Picture 13

14 From Default to Equity Risk If you are lending money to a business, or buying bonds, it is default risk that you are focused on, but if you own a business, your exposure to risk is far broader, since your claims are residual. This is equity risk. If there are variations in default risk across countries, it stands to reason that equity risk should also vary across countries, leading investors and business owners to demand different equity risk premiums in different parts of the world. 14

15 Two Propositions on Country Risk Proposition 1: If country risk is diversifiable and investors are globally diversified, the equity risk premium should be the same across countries. If country risk is not fully diversifiable, either because the correlation across markets is high or investors are not global, the equity risk premium should vary across markets. Proposition 2: If there are variations in equity risk premiums across countries, the exposure of a business to that risk should be determined by where the business operates (in terms of producing and selling its goods and services), not where it is incorporated. 15

16 Estimating Equity Risk Premium for a Country 16

17 ERP: A Global Picture 17

18 Incorporating Country Risk into Valuation: Coca Cola, with Revenues 18

19 Incorporating Country Risk into Valuation: Royal Dutch, with Production 19

20 Incorporating Country Risk Into Investment Analysis Assume that Coca Cola is considering making investments in Nigeria, Chile and US and is trying to estimate the "right" cost of equity to use in its assessment. Even if all of the investments are in identical businesses (soft drinks) and are in the same currency (US dollars), the costs of equity will vary across them (the beta for Coca Cola is 0.80 and the risk free rate is 3%): Nigeria project: Risk Free Rate +Beta* (Nigeria ERP) = 3% (13.15%) = 13.52% Chile project: Risk Free Rate +Beta* (Chile ERP) = 3% (6.22%) = 7.98% US project: Risk Free Rate +Beta* (USA ERP) = 3% (5.37%) = 7.30% It is worth noting that many companies still adopt the practice of using the same hurdle rate for investments in different markets and if Coca Cola adopted this practice, it will reduce the cost of equity for the Nigerian investment and raise it for the Chilean and Canadian investments, and over time, it will lead Coca Cola to over invest and over expand in the riskiest markets. 20

21 Incorporating Country Risk into Pricing If equity risk varies across countries, you should also expect to see it show up in PE ratios or EV/EBITDA multiples, with companies in riskier markets trading at lower values. This can be viewed as an argument for finding comparable firms in markets of equivalent risk, but as we saw with Coca Cola and Royal Dutch, that can be difficult to do. Since there are often far fewer companies listed in many emerging markets, you have no choice but to look outside your market for comparable firms, and when you do so, you have to at least consider differences in country risk, when making your judgments. If you do not, and you are comparing publicly traded retailers across Latin America, companies in riskier markets (like Venezuela, Argentina and Ecuador) will look cheap relative to companies in safer markets (like Chile and Colombia). 21

COST OF CAPITAL: REVISITING BASICS & GETTING PERSPECTIVE. Aswath Damodaran

COST OF CAPITAL: REVISITING BASICS & GETTING PERSPECTIVE Aswath Damodaran Cost of Capital: A Financial Balance Sheet Perspective 2 The Swiss Army Knife 3 Every Risk has a place 4 1. Business Risk If you