691 35 Emerging Markets* The world’s emerging economies, home of 86 percent of the population, ac- counted for about 59 percent of global GDP in 2017 and are growing faster than the developed economies.1 As emerging markets become more important to the global economy and to investors, sound methods are needed for analyz- ing and valuing companies and business units in these markets. Chapters 26 and 27 discussed general issues related to forecasting cash flows, estimating the cost of capital in a foreign currency, and incorporat- ing high inflation rates into cash flow projections. This chapter focuses on additional issues that arise in emerging markets, such as the potential for extreme economic contractions or unexpected government actions like asset appropriation. It is impossible to generalize about these risks, as they differ by country and may affect businesses in different ways. Academics, invest- ment bankers, and industry practitioners subscribe to different methods and often make arbitrary adjustments based on intuition and limited empirical evidence. For accurate valuation of companies in emerging markets, we recommend using a scenario discounted-cash-flow (DCF) approach as described in Chap- ter 16 to prepare multiple cash flow scenarios reflecting the outcomes of dif- ferent risks that a company could face. These scenarios are each discounted and then weighted by probabilities assigned to each. You can supplement this method by comparing the results with two secondary approaches: a DCF valuation with a country risk premium built into the cost of capital and a valu- ation based on the multiples of comparable companies. * The authors would like thank Andre Gaeta, Daniel Guzman, Paulo Guimaraes, Joao Lopes Sousa, and Barbara Castro for their contributions to this chapter. 1 China’s and India’s shares of global GDP, at purchasing parity prices (PPP), were 19 and 8 percent, respectively, and 19 and 18 percent of population, respectively. International Monetary Fund, “GDP Based on PPP, Share of World,” IMF DataMapper, imf.org. 692  Emerging Markets Why Scenario DCF Is More Accurate than Risk Premiums The most vigorously debated issue about valuing companies in emerging mar- kets is whether to incorporate a country risk premium in the cost of capital. A common practice has been to add a country risk premium to the discount rate to account for the higher risks of operating in emerging markets.2 Often, the premium is based on the government’s borrowing rate relative to a bench- mark, such as the borrowing rates for the U.S. government. A major problem with this approach is that the riskiness of lending to a government may have little to do with the risk of investing in a business. It is possible for a company to have a cost of equity that is lower than the inter- est rate on the government debt in the country. This seems counterintuitive, but compare the riskiness of a consumer packaged-goods (CPG) producer in an emerging market versus the government debt of that country. The CPG producer may experience a large drop in earnings during an economic crisis, but it typically springs back relatively quickly. And in contrast to the political environment facing banks and mining or energy companies, CPG businesses face little risk of appropriation by the government. With regard to government debt, however, it’s not unusual for governments to default. Since 1990, Russia and Argentina have each defaulted, and oil-rich Nigeria has defaulted three times. Even Greece required bailout loans from the International Monetary Fund and European Central bank in 2010, 2012, and 2015. It’s also possible that the cost of debt for some companies is lower than that of their govern- ment, as is the case in Brazil, where a number of companies’ debt is rated investment grade while the government’s is not. Furthermore, it’s illogical to apply the same risk premium across all in- dustries. CPG producers generally survive economic disruptions, while banks may go bankrupt. For example, over the period 2013–2018, Brazilian ten-year government bonds were more volatile than beverage company Ambev and less volatile than the major Brazilian banks. Some companies (raw-materials exporters) might benefit from a currency devaluation, while others (raw- materials importers) will be damaged. We’ve also found that the country risk premiums used in practice are too high and lead to overcompensation in the company’s projected performance. Analysts using high premiums frequently compensate by making aggressive forecasts for growth and return on invested capital (ROIC). An example is the valuation we undertook of a large Brazilian chemicals company. Using a local weighted average cost of capital (WACC) of 10 percent, we reached an enter- prise value of 4.0 to 4.5 times earnings before interest, taxes, depreciation, and amortization (EBITDA). A second adviser was asked to value the company 2 T. Keck, E. Levengood, and A. Longfield, “Using Discounted Cash Flow Analysis in an International Setting: A Survey of Issues in Modeling the Cost of Capital,” Journal of Applied Corporate Finance 11, no. 3 (1998): 82–99.