Valuing Emerging Market Equities—A Pragmatic Approach Based on the Empirical Evidence

• DOI: http://doi.org/10.1111/jacf.12107
• Author: Niso Abuaf
• Published date: 01 March 2015
• Date: 01 March 2015

In This Issue: Corporate Risk Management

Risk-Taking and Risk Management by Banks 8René M. Stulz, Ohio State University

Risk Management by Commodity Trading Firms: The Case of Tragura 19 Craig Pirrong, University of Houston

How to Strengthen the Regulation of Bank Capital: Theory, Evidence,

and A Proposal

27 Shekhar Aiyar, International Monetary Fund,

Charles W. Calomiris, Columbia University, and

Tomasz Wieladek, Bank of England

When One Size Doesn’t Fit All: Evolving Directions in the Research and Practice of

Enterprise Risk Management

37 Anette Mikes, HEC Lausanne, and Robert S. Kaplan,

Harvard Business School

Evidence of the Value of Enterprise Risk Management 41 Robert E. Hoyt, University of Georgia, and

Andre P. Liebenberg, University of Mississippi

Here We Go Again…Financial Policies in Volatile Environments:

Lessons For and From Energy Firms

48 Marc Zenner, Evan Junek, and

Ram Chivukula, J.P. Morgan

Corporate Hedging of Price Risks: Minimizing Variance or

Eliminating Lower-Tail Outcomes?

57 Tom Aabo, Aarhus University, Denmark

OTC vs. Exchange Traded Derivatives and Their Impact on

Hedging Effectiveness and Corporate Capital Requirements

63 Ivilina Popova, Texas State University, and

Betty Simkins, Oklahoma State University

Valuing Emerging Market Equities—A Pragmatic Approach

Based on the Empirical Evidence

71 Niso Abuaf, Pace University and Ramirez and Co.

A Practical Guide for Non-Financial Companies When Modeling

Longer-Term Currency and Commodity Exposures

89 Lurion De Mello and Elizabeth Sheedy, Macquarie

University, and Sarah Storck, Technical University Munich

Renewable Energy with Volatile Prices: Why NPV Fails to Tell the Whole Story 101 Ricardo G. Barcelona, King’s College, London and

IESE Business School

Real Options in Foreign Investment: A South American Case Study 110 Michael J. Naylor, Jianguo Chen and Jeffrey Boardman,

Massey University

VOLUME 27 | NUMBER 1 | WINTER 2015

APPLIED CORPORATE FINANCE

Journal of

Journal of Applied Corporate Finance • Volume 27 Number 1 Winter 2015 71

Valuing Emerging Market Equities—

A Pragmatic Approach Based on the Empirical Evidence

* The author thanks Saichalee Bee Limaphichat for invaluable research assistance,

and Don Chew for signicant editorial guidance.

1. These approximations are based on the statistical evidence presented in one of my

earlier studies, but with a slight variation. See Abuaf (2011). (Full citations of all articles

are provided in the References at the end.) In that research, I regress returns on ADRs

against returns on the S&P 500 (both represented as log differences) and levels of CDS

spreads, which is the proxy for countr y risk used throughout this paper. In this paper,

however, I modify my earlier research such that the second independent variable is the

change in, as opposed to the level of, the CDS. Using this method, the coefcient of the

S&P 500 would be interpreted as the traditional beta, and the coefcient of the change

in CDS would be interpreted as the modied duration of equities (also known as the

“semi-elasticity”) with respect to CDS. That is, the coefcient of the CDS represents the

percentage change in the cost of equity for a given percentage point change in CDS.

Thus, the higher this coefcient, the greater the exposure of a given stock or industry to

country risk.

2. See Abuaf and Chu (1991, 1994) and Abuaf, Chu, Czapla, Lawley and Thadani

(1997).

3. See Stulz (1995). Stulz’s nding is similar to a small cap premium in the Fama-

French model in the sense that, just as we would expect a premium for investing in

small-cap stocks, we might expect a premium for investing in emerging markets, which

may behave like small-cap stocks.

BT

hough practitioners and academics rely on sim ilar

conceptual fra meworks when valuing interna-

tional equities in general a nd emerging market

equities in particu lar, they emphasize dierent

aspects of the fra mework. In contrast to academic s, practi-

tioners adjust discount rates as opposed to cash ows , and use

the U.S. instead of the global equity m arket risk premium.

In this paper, I propose a pragmatic approach to estimat-

ing the cost of equity for industr y groups operating in African,

Asian, and Lati n American emerging markets, a nd high-risk

European markets a s well. Grounded in observed empirical

estimates, my approach has t wo building blocks:

1. Use of the U.S.-based Capital Asset Prici ng Model

(CAPM) with a beta that is designed to represent industry

(instead of individual company) risk.

2. An adjustment of the U.S.-based CA PM that involves

assigning a cert ain proportion—from 35% to as much as

100%—of a given countr y’s political risk to a specic i ndus-

try. ese proportions are approximations that are mea nt to

reect the extent of an industr y’s exposure to country risk.1

When the worldwide privatization boom began in the

late 1980s, sellers, buyers, and nancial intermediaries recog-

nized their need for a framework for valuing assets in dierent

regions of the world. But standard international corporate

nance theory could oer little assistance, primarily because

it continued to insist that when valuing, say, telephone assets

in Mexico, one should account for Mexican risk by adjust-

ing the expected cash ows and then discounting these cash

ows using a U.S.-based weighted average cost of capital

(WACC). e appeal of this approach is its similarity to

valuing telephone assets in the U.S. e problem, however,

was that analysts had no intuitively satisfying way of adjusting

cash ows to reect country risks, such as those encountered

when investing and operating in Mexico.

As an alternative met hod, a number of colleagues a nd

I have proposed a pragmatic approach to capturi ng the eects

of country risk by increasin g the cost of equity, which results

in an increase in the WACC.2 Using such an approach, and

assuming well-integrated global capital market s, one would

view the risk associ ated with the Mexican telephone assets as

consisting of two par ts:

• U.S. telephone-a sset risk and

• e additional risk associated with a n investment in

Mexico.

Such an approach, which has been embraced by some

academics as well a s many (if not most) practitioners, reects

a departure from the cla ssic theoretical approach th at calls

for modeling the risk of the telecommunic ations industry

worldwide, and then using a global telecom bet a to adjust

the expected return s on the global capital market s. In some

versions of this classic approach, a fur ther adjustment is used

to take account of dierences of Mex ico’s telec om beta from

a global or U.S. telecom beta—dierences that could ari se

from dierences in the life- cycle maturity, or other industry

characteristic s, of the Mexican telecom industry.

A Brief Look at Existing Approaches

ere is a rich body of applied literature on the valuation of

international equities and invest ments, particula rly as they

relate to emerging market invest ments. What follows is a brief

summary of positions ta ken by a number of nance scholars

and practitioners since the early 1990s:

• In 1995, Ohio State professor Rene Stulz noted an

“increasing synchronization (or correlation) of both real

international business activ ity and world nancial markets,”

a phenomenon that he argued was “partly oset ting the

benets of global diversicat ion.”  is nding suggested that

investors would nd it increasingly dicu lt to improve their

by Niso Abuaf, Pace University and Ramirez and Co.*