The whole world is more connected to each other than ever before. With the advancements in technology & science, from all corners of the world economies, have become independent.
Emerging markets and businesses and advanced economies are now easily reachable to consumers & investors in developed countries.
In fact, many mutual fund managers and investors encounter the common problem that how to evaluate a company properly which can do business in emerging market economies.
In this guide, we will look at the points that should be considered before placing value on or evaluating emerging markets.
Better use Discounted Cash Flow Analysis for Evaluation
It might seem too difficult to place a value on an emerging market firm, but it is not really too difficult to evaluate a company from a developed country. The strength of evaluation is still DCF (discounted cash flow analysis). The purpose to use this method is to simply calculate how much money an individual investor would get back from an investment.
Even if the subject is the same, there are a few factors that may still be specific to dealing with the emerging market. For example when you are analyzing emerging market firms that there are some serious concerns like the effect of exchange rates, inflation, and interest rates.
Most analysts don’t give importance to the exchange rates, although the local currencies of emerging market nations can be large in relation to the dollar, they seem to stay close to the country’s PPP (purchasing power parity).
So domestic business may be less affected by the changes in the exchange rate in an emerging market firm. Inflation can be a game-changer on evaluation, particularly when a firm operates in probable high inflation settings.
It is very important to calculate future cash flow in both the manner nominal and real terms in order to survive the impact of inflation on a discounted cash flow estimate for an emerging market firm.
Accommodation for estimating DCF in Emerging Markets
Cost of Capital – It plays a major role to estimate the free cash flow in emerging markets. The cost of debt and the firm’s equity cost is more challenging to calculate in emerging markets. The risk-free rate is very difficult to estimate in emerging markets. Even government bonds cannot be taken as riskless investments.
Cost of Debt – By using the spreads that are comparable in the case of determining the cost of debt from a developed country. The myth considers that in emerging markets risk-free rate is not free of risk. In fact, to select a perfect capital structure, it is good practice to use the industry average. In case there is no local average available using a global or regional average may give the result as well.
Calculated Average Cost of Capital
There is some difficult rule to choosing the nation’s risk premium. In fact, sometimes individual investors will overestimate the premium. A good practice to calculate the average cost of capital is to the historical returns of that company’s stocks is considered.
Peer Comparison
Last but not least evaluating most of the companies from developed nations compare the firm to the industry peers on multiple bases. Estimating the company against a similar type of emerging market firm on multiple bases.