Excessive risk premiums when valuating companies in emerging markets? Exploring the risks of undervaluing companies in emerging markets

Thomas Stenfeldt Batchelor

Student thesis: Diploma thesis


The thesis explores the risk of undervaluing companies in emerging markets and identifies key factors that can be contributing to such undervaluation with a focus on the wide-spread practice of applying country risk premiums. The thesis does not explore empirical data in order to document whether undervaluation actually occurs but based on the well founded assumption that practitioners often apply a country risk premium (based on sovereign debt spreads) the thesis firstly explores the corporate finance theory upon which the generally applied DCF-valuation models are based. This provides a basis for analyzing what key elements of the DCF-valuation are affected by the fact that the target company being valued operates in an emerging market and the technical and theoretical challenges related to this context are discussed. The main issue being that a country risk premium is largely unfounded in theory, due to the fact that the WACC should not be increased in an emerging market context with a reference to country risks which are predominantly uncorrelated to the global financial markets and thus should be disregarded as unsystematic by a globally diversified investor. Even to the extent that a certain form of risk premium should be applied, the analysis shows that such a premium should not be equal to the sovereign bond spreads related to the country in which the company is based, but rather to a company specific risk premium, which may be based on the spread but which should take into account the risk exposures of the specific company in question and the (often limited) correlation to the risk of sovereign debt default. Finally, a company specific risk premium should be ensured not to double count risks, e.g. if a risk factor has been taken into account in a scenario upon which the DCF-valuation is based, then the risk premium should be reduced accordingly. Another point derived from the analysis is the importance of capturing the value of managerial flexibility and real options to leverage the emerging market acquisition as a platform. Such value can be missed in a standard DCF-valuation and it is thus recommended to use decision tree analysis or real option valuation in order to capture this type of value. This requires a more thorough analysis of when management can take key decisions influencing the cash flow going forward, e.g. by phased CAPEX for production capacity or sales & marketing. Although the thesis arrives at the conclusion that many practitioners should be able to be more aggressive when valuing emerging market companies, this is not to be confused with a conclusion that diminishes the challenges associated with acquisitions in emerging markets. A range of practical issues ranging from financial intransparency to cultural differences make deal execution and especially integration of emerging market acquisitions more challenging than acquisitions in developed markets. The key point of the thesis is, however, that there is neither reason nor theoretical justification for linking such challenges and associated risks to the application of very substantial country risk premiums when valuing an emerging market company.

EducationsGraduate Diploma in Finance, (Diploma Programme) Final Thesis
Publication date2010
Number of pages68