Estimating Cost of Capital in Emerging Markets  699 their home market. As a result, local investors in such markets cannot always hold well-diversified portfolios, and their cost of capital may be considerably different from that of a global investor. Unfortunately, there is no established framework for estimating the capital cost for local investors. However, if the local stock market is fully integrated into the global markets (investors both in and out of the country can freely trade both locally and internationally), local prices will more likely be linked to an international cost of capital. Another assumption is that, from the perspective of the global investor, most country risks are diversifiable. We therefore need no additional risk premiums in the cost of capital for the risks encountered in emerging mar- kets when discounting expected cash flows in the scenario DCF approach. Of course, if you choose to discount the promised cash flow from the business- as-usual scenario only, you should add a separate country risk premium, as discussed earlier. Given these assumptions, the cost of capital in emerging markets should generally be close to a global cost of capital adjusted for local inflation and capital structure. It is also useful to keep some general guidelines in mind: • Use the capital asset pricing model (CAPM) to estimate the cost of equity in emerging markets. The CAPM may be a less robust model for the less integrated emerging markets, but there is no better alternative model today. • There is no one right answer, so be pragmatic. In emerging markets, there are often significant gaps in information and data (for example, in es- timating betas). Be flexible as you assemble the available information piece by piece to build the cost of capital. • Be sure monetary assumptions are consistent. Ground your model in a com- mon set of monetary assumptions to ensure that the cash flow forecasts and discount rate are consistent. If you are using local nominal cash flows, the cost of capital must reflect the local inflation rate embedded in the cash flow projections. For real-terms cash flows, subtract inflation from the nominal cost of capital. • Allow for changes in cost of capital. The cost of capital in an emerging- market valuation may change, based on evolving inflation expectations, changes in a company’s capital structure and cost of debt, or foresee- able reforms in the tax system. For example, in Argentina during the economic and monetary crisis of 2002, the short-term inflation rate was 30 percent. This could not have been a reasonable rate for a long-term cost of capital estimate, because such a crisis could not be expected to last forever.6 In such cases, estimate the cost of capital on a year-by-year basis, following the underlying set of basic monetary assumptions. 6 Annual consumer price inflation came down to around 5 percent in Argentina in 2004. 700  Emerging Markets • Don’t mix approaches. Use the cost of capital to discount the cash flows in a scenario DCF approach. Do not add any risk premium, because you would then be double-counting risk. If you are discounting only future cash flows in a business-as-usual scenario, add a risk premium to the discount rate. Estimating the Cost of Equity To estimate the components of the cost of equity, use the approach described in Chapter 15, with the following considerations for the risk-free rate, market risk premium, and beta. In emerging markets, it is harder than in developed markets to estimate the risk-free rate from government bonds. Three main problems arise. First, most of the government debt in emerging markets is not, in fact, risk free: the ratings on much of this debt are often well below investment grade. Second, it is difficult to find long-term government bonds that are actively traded with sufficient liquidity. Finally, the long-term debt that is traded is often in U.S. dollars or the euro, so it is not appropriate for discounting local nominal cash flows. We recommend a straightforward approach. Start with a risk-free rate based on the ten-year U.S. government bond yield, as in developed markets. Add to this the projected difference over time between U.S. and local inflation, to arrive at a nominal risk-free rate in local currency.7 For emerging-market bonds with relatively low risk, you can derive this inflation differential from the spread between local bond yields denominated in local currency and those denominated in U.S. dollars. Sometimes practitioners calculate beta relative to the local market index. This is not only inconsistent from the perspective of a global investor, but also potentially distorted by the fact that the index in an emerging market will rarely be representative of a diversified economy. Instead, estimate industry betas relative to a well-diversified or global market index, as recommended in Chapter 15. Excess returns of local equity markets over local bond returns are not a good proxy for the market risk premium. This holds even more so for emerg- ing markets, given the lack of diversification in the local equity market. Fur- thermore, the quality and the length of available data on equity and bond market returns usually make such data unsuitable for long-term estimates. To use a market risk premium that is consistent with the perspective of a global investor, use a global estimate (as discussed in Chapter 15) of 4.5 to 5.5 percent. 7 Technically, we should also model the U.S. term structure of interest rates, but it will not make a large difference in the valuation.