In our financially interconnected world where there are few restrictions on where M&A deals can be carried out, one major practical transaction challenge that investors and companies face is the valuation of companies and assets in emerging markets.
Emerging market valuation can be difficult due to several reasons, including:
– the key revenue and cost drivers of a company’s business may be highly exposed to microeconomic or macroeconomic variables that are rapidly changing
– there may be a limited number of transactions in a market involving a particular asset or company type which creates a high degree of uncertainty about what an asset or company is worth
– there may be country risks, such as political or social risks, which create significant uncertainty about how the business environment a company operates in will change in the future.
These difficulties often lead to situations where companies or assets are significantly overvalued or undervalued, creating unrealistic investment return expectations, investor and company tensions that negatively affect a company’s performance and, most importantly, inefficient patterns of capital allocation and repayment that can restrict business and economic growth.
This article briefly defines the concept of an emerging market in the valuation context, discusses some emerging market valuation challenges and sets forth guidelines that companies and investors can use when they face valuation challenges in these markets.
What is an Emerging Market?
While the term “emerging market” is often used as a shorthand way to refer to countries that are entering a phase of significant economic growth, from a financial valuation perspective the concept of an emerging market is often not so straightforward.
The reason for this is that every country is in reality comprised of many different markets, and these markets are in a constant state of flux with some markets growing, others in a state of relative stability and other markets in a phase of decline. Even with respect to markets that are in a phase of decline in terms of total market size or profit margins, the application of new technologies may cause these markets or sub-markets to enter new periods of high growth.
For the purpose of valuation, it is therefore helpful to identify three types of emerging markets:
– the first type of emerging market is a country that is undergoing a phase of rapid economic growth. This is growth which is significantly better than historical growth rates and has been sustained for at least several years. To provide one example of a classic emerging market, since 2002, Ethiopia’s annual GDP growth rate has exceeded 10% many times
– the second type of emerging market is a sub-market in an economically mature market, such as the United States, that is currently undergoing a phase of rapid economic growth. An example of this type of market is green vehicle technology
– the third type of emerging market is a market which is the result of the combination of two markets, such as the financial sector and technology, producing the fintech market.
These emerging market types highlight the point that regardless of how a market is labelled, the actual market realities a company operates in can be highly dynamic and complicated.
Valuation Challenges in Emerging Markets
Valuing assets and companies in emerging markets presents significant challenges, both from market-based as well as cash flow-based valuation approaches.
Market-Driven Valuation Approaches
A common way for companies to be valued is to derive valuation metrics from the market, such as based on the relationship between company sale prices and company revenues or EBITDA. However, in emerging markets there can be very little transaction history regarding a company or asset type, so these metrics may not exist
Cash Flow-Based Valuation Approaches
Another common way for companies to be valued is to forecast the company’s future cash flows and then discount the value of those cash flows by a discount factor based on risk. In emerging markets, however, this can be very challenging to do because first, as suggested above, there may be not enough transaction history to extract a discount factor. More importantly, emerging markets often experience high degrees of volatility and accordingly cash flows and risk levels can be highly susceptible to change, either moving to more stability, lower risk and lower growth rates or becoming significantly riskier and at times even collapsing.
Emerging Market Valuation Principles
To face the challenges of emerging market valuation, it is helpful to keep the following points in mind:
– Definition of Market. The first point is to accurately define the market that the relevant company or asset is in. It is often the case that a company in an ostensibly highly stable market is actually positioned in a sub-market experiencing significant growth which may be not be reflected in the valuation metrics applicable to transactions in the broader market. Similarly, a company in a highly volatile emerging market may actually have a business model which is highly stable and insulated from a significant amount of market volatility, such as a company in an emerging market whose sales are based on long-term contracts with highly stable buyers.
– Definition of Company Relationship to Market Drivers. The second point is to analyze the relationship of a company’s business model to market drivers. For some business models, such as construction, there tends to be a high correlation between the company’s business model and a country’s GDP growth. Other business models, however, may benefit during periods of macroeconomic volatility, such as those based on debt renegotiation or selling discount products and services.
– Use of Other Markets as Valuation Reference Points. In the absence of sufficient transaction history in a market for valuation purposes, it is useful to use metrics in other markets as a starting point. While different markets can have very different realities, many business models of companies in the same industry, even if they are located in different jurisdictions, are structurally similar which can help define income and cost structures and profitability.
Once this is done, it is then necessary to compare the company to be valued with companies in the reference market to see whether the reference valuation parameters should be adjusted upwards or downwards. Some key factors to consider in this comparative analysis are:
– The profitability of the company to be valued compared with companies in the valuation reference group;
– Risks to the company’s current revenue and cost structure compared with risks that affect the company’s valuation reference group;
– Size of a company’s potential growth market compared with companies in the valuation reference group; and
– Ability of a company to take advantage of that growth market compared with companies in the valuation reference group, based on such factors as strength of the companies’ leadership and management teams, the nature of competitors in the market, barriers to market entry and regulatory factors that promote or restrict competition.
Due to the integration of global capital markets and low economic growth rates in mature markets, investors will continue to look for investment opportunities in emerging markets and companies in emerging markets will continue to search more developed markets for investment capital.
While investing across markets at different stages of development presents significant valuation challenges, through a careful analysis of market realities and comparing the structure and prospects of a company’s business model to companies in a reasonably selected valuation reference group, it is possible to obtain a valuation of a company or asset in an emerging market that is fair for investors as well as target companies. This is necessary to match investment capital with investment opportunities and create continually more efficient markets.
This article was written by Darin Bifani, ONEtoONE Partner in Chile