Valuation Methods in Emerging Markets

Abstract

This thesis investigates how country risk can be incorporated into firm valuation models in emerging markets, addressing the challenges of valuing companies under significant macroeconomic and political uncertainties. The study compares the Extreme Scenario Framing (ESF) method with the traditional Country Risk Adjusted Discount Rate (CRADR) approach through a case study of three Brazilian firms. The theoretical framework indicates that no single consensus method exists; however, CRADR is widely applied for its simplicity. CRADR’s static nature and reliance on an added country risk premium, motivates the adoption of the more dynamic ESF approach. In this research, the ESF methodology, originally proposed by Pereiro (2009), is adapted for practical application. The adaptation employs a Global CAPM for the discount rate, weights scenario probabilities by historical currency crisis frequency, and uses a Gordon Growth model for terminal value estimation. Key macroeconomic and political risks in Brazil are incorporated into two scenarios. An optimistic scenario, which assumes controlled inflation, fixed development in the exchange rate, and political stability and a pessimistic scenario which reflects severe currency devaluation, persistent inflation, and heightened political interference. The analysis finds that ESF provides a more nuanced and flexible handling of country risk, yielding higher valuation estimates for the case companies compared to CRADR. However, the ESF approach requires significant analyst discretion and is more subjective due to its less established theoretical foundation. In contrast, CRADR offers a straightforward, and user-friendly framework. Overall, ESF deepens understanding of firms’ exposure to country specific risks and allows more transparent inclusion of such risks in valuations. However, CRADR remains a convenient tool for investors and analysts prioritizing simplicity and objectivity in emerging market investment decisions.