Using Scenarios instead of Country Risk Premia

(By Vartika Gupta, CFA )

In recent blogs, we have discussed whether country risk is diversifiable and if risk premia for emerging markets are overstated. While our analysis does not really prove that there is no country risk premium, it's clear that common numbers are way overstated. We would therefore argue that adding CRP is not the best way to value a project in emerging markets (or anywhere).

• Premiums are often set too high, usually to compensate for far too aggressive or not well thought out business plan projections. However, when you use discount rates that are only three to five percentage points higher than the estimated cost of capital, you massively increase estimates of not making any cash flow. Adding three percentage points to an 8 percent cost of capital for an acquisition, for example, can reduce its present value by 30 to 40 percent (depending on its long-term growth rate). Here is a good article by Marc Goedhart illustrating this with simple math.
• Not all industries are equal. Somehow, this is all discussed as one country risk. However, there are many different types of companies. For instance, in case of a nationalization event in an emerging country focusing on extraction industries, a multinational consumer goods company may not see any impact on its operations vs a mining company which may lose its right to the mines. Or, even clearer, a mining company that sells its products in USD in global markets is not exposed to a lot of currency risk, and therefore sheltered from most local economic risk (but exposed to the nationalization!).

In the end, we are trying to estimate the expected cash flows of the project or the business. If we do that correctly, the risk is taken care of. So in many cases, a much better approach for determining the expected value of a project is to develop multiple business, risk, and cash-flow scenarios, preferably including at least one downside case, value them at the unadjusted cost of capital, and then calculate the average weighted by the probability that each will happen (Exhibit 1).

Practically, the cost of capital should be estimated using the same approach as in developed countries. To estimate the risk free rate, we recommend using the USD risk free rate and ?adding an inflation differential to the local currency. The market risk premium should also be considered with the perspective of a global investor at ~5%. The most important aspect here is consistency in assumptions for cash flow forecasts and cost of capital (e.g., in terms of inflation assumption)

This approach not only provides decision makers with more information about the risk, it also encourages managers to develop strategies to mitigate specific risks?and acknowledges the full range of possible outcomes (not only where everything goes well). In a recent set of interviews, we also found that practitioners see the value in the discussion of the risk, the mitigation opportunities, and the impact - not in the actual probabilities. This makes sense - you will never be able to nail down the exact probabilities, and there is a big danger to get stuck in the attempt to do the perfect. The risk discussion based on scenarios, however, is highly valuable for decision makers.

(This article by Ryan Davies , Tim Koller , and Marc Goedhart has more details on the scenarios approach)

Adding an extra country risk premium to the cost of capital doesn’t add insight; it obscures it.?Scenario-based approaches have the dual appeal of better answers and more transparency on the assumptions embedded within them.