Valuation of a company abroad

Valuation of a company abroad

Right now I am writing several blogs on “business valuation”.

I got inspired to do this after reading the fantastic book: “The real cost of capital: A business field guide to better financial decisions” (2004).

The book is written by Tim Ogier & John Rugman & Lucinda Spicer. This book is used as a source for the blogs.

In this sequence I have written 9 blogs already. You can find the links to the precedent blogs at the end of this one.

Here you can also find many more blogs/ articles on valuation and M&A and my international training calendar in valuation for spring 2020.

International valuation

In an international environment when applying DCF (discounted cash flow) valuation to companies in different countries there are additional things to take care of.

First we need to think about how to calculate the cost of equity and the WACC (weighted average cost of capital).

And second, we need to think about what to do with complexities of dealing with cash flows affected by differences in relative inflation and exchange rates.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Treatment of cash flows in international valuation

We have looked already in earlier blogs on how do deal with the cost of equity and the WACC internationally.

So let’s now take a look at how deal with cash flows in international valuation.

There are two basic options for performing international valuations. Both start with cash flows stated in the foreign currency. So the currency of the foreign company that we want to value.

Method 1

This method converts the foreign currency cash flow into familiar domestic currency values. And here for future exchange rates need to be forecasted.

After that a familiar home discount rate is applied to calculate a home currency NPV (net present value). And as we know NPV stands in the end for the enterprise value.

For the discount rate a country risk adjustment is made, assuming that the cash flows to which the discount rate is to be applied, have not yet already been adjusted for country risk.

Method 2

This method applies a foreign currency discount rate to the foreign currency cash flows to estimate a foreign currency NPV.

This foreign currency NPV can then be converted into a home currency NPV at the prevailing spot exchange rate between the two currencies.

Implicitly is assumed within this method that the cash flows have not been adjusted for country risk either.

Since the foreign currency cost of capital already includes a country risk premium component in the local currency risk free rate component of the calculations.

Now let’s take a look at these two methods in a little more detail.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Method 1: Currency conversion

Method 1 requires forecasts of the future exchange rate between the currency of the investor’s home country and of the country where the investment (e.g. company) is located.

The best way to do this is by using the forward exchange rate quoted in the market. But in practice these do not usually cover a period more than a couple of years.

Although, longer forecasts can be produced by assuming that “purchasing power parity” (PPP) holds.

PPP states that because of the possibility of arbitrage, the prices of products should be the same internationally.

This implies that if inflation is higher in one country than in the other, then the value of its currency should depreciate in relative terms to offset the differential inflation.

So when you know the spot rate and expected inflation of the two countries, then you can calculate the expected exchange rates. This in order to be able to translate future cash flows in the home currency.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Method 1: Currency risk

Another issue in method 1 is the question whether a premium for currency risk should be added to the discount rate?

Some practitioners argue that a currency risk premium is unnecessary.

This because with exchange rate forecasts there is an equal probability that the outturn exchange rate will exceed the forecast exchange rate as that it will fall below. So these currency risks should be diversifiable.

By holding a portfolio of overseas investments, investors can diversify the risk of adverse exchange rate movements in one country against another.

This sounds intuitive and is practical.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Method 2: Foreign currency NPV

The foreign currency discount rate used here in the DCF takes into account inflation in the country where the investment (e.g. a company) is located.

Assuming that inflation is higher in the foreign country than in the country of residence of the investor, then this implies that the nominal discount rate used in method 2 is higher than in method 1 due to the inflation rate differential.

The effect is that:

1.     Future cash flows in foreign currency are discounted back with a foreign currency discount rate;

2.     Then this foreign currency NPV is converted with the spot exchange rate to the NPV in the currency of the investor’s country of residence;

3.     So the exchange rate of the foreign currency implicitly gets depreciated with the “inflation rate differential”, because the foreign currency discount rate takes inflation into account;

4.     This implicitly equals the PPP methodology under method 1.

So in the end the outcomes of method 1 and 2 should be the same.

It just depends on which method the valuator and/ or M&A consultant finds the most practical.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Sources used for this blog

·       The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer. 9780273688747.

This book is fantastic and very practical, just a pleasure to read for every investment professional. Highly recommended! ??

Earlier blogs on the “cost of capital”

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/

Article 9: Valuation: Different DCF & WACC techniques

https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/

Earlier blogs on “Business valuation to Enterprise Value”

From June until August I have written the following blogs on valuation:

1)    Leveraged Buyout (LBO) Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

2)    M&A Analysis – Accretion/ Dilution:

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

3)    Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

4)    Valuation Multiples 1 – Comparable Companies Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

5)    Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

6)    Valuation Multiples 2 – Precedent Transaction Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

Earlier blogs on Wall Street

Article 1: Wall Street – A general introduction

https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/

Article 2: Wall Street – The Federal Reserve banking system

https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/

Consultant & Trainer Joris Kersten

I am an independent M&A consultant and Valuator from The Netherlands.

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East). This at (investment) banks, corporates and universities.

Also I provide inhouse training on request and I have open training programs in business valuation in The Netherlands and all over the world.

Training agenda Joris Kersten:

• Financial Modelling in Excel (5 days): 2, 3, 4, 5, 6 February 2020. Location: Riyadh/ Saudi Arabia;
• Business Valuation & Deal Structuring (6 days): 18, 19, 20, 21 and 23, 24 March 2020. Location: Uden/ The Netherlands;
• Financial Modelling in Excel (4 days): 20, 21, 22, 23 April 2020. Location: Uden/ The Netherlands;
• Business Valuation & Deal Structuring (5 days): 22, 23, 24, 25, 26 June 2020. Location: New York City/ United States.

All info on these open training sessions can be found on: www.kerstencf.nl/training

And 130 references on my training sessions can be found on: www.kerstencf.nl/referenties