The growth of financial markets in Asia and Latin America and the allure of globalization has made the analysis and assessment of country risk a critical component of valuation in recent years. In this paper, we consider two issues. The first is the whether country risk should be considered explicitly in valuation, and if the answer is yes, how to do it. Generically, there are two ways of incorporating country risk; we can either adjust the cash flows or change the discount rate and we will consider both approaches.
The second and equally important issue is how to assess a company’s exposure to country risk and we will emphasize two points. The first is that not all companies in an emerging market are equally exposed to country risk and that we need to differentiate between firms. The second is that a company’s exposure to country risk comes not from where it incorporates and trades but from where it does its business. In other words, assessing and dealing with country risk can be important even for companies that trade in developed markets, if they get a significant portion of their revenues in emerging markets.
As companies and investors globalize and financial markets expand around the world, we are increasingly faced with estimation questions about the risk associated with this globalization. When investors invest in Petrobras, Gazprom and China Power, they may be rewarded with higher returns but they are also exposed to additional risk. When Coca Cola and Nestle push for growth in Asia and Latin America, they clearly are exposed to the political and economic turmoil that often characterize these markets.
In practical terms, how, if at all, should we adjust for this additional risk? In the first part of the paper, we will review the discussion on country risk premiums and how to estimate them. In the latter part of the paper, we will focus on a related question: Once we have estimated a country risk premium, how do we evaluate a company’s exposure to country risk? In the process, we will argue that a company’s exposure to country risk should not be determined by where it is incorporated and traded.
By that measure, neither Coca Cola nor Nestle are exposed to country risk. Exposure to country risk should come from a company’s operations, making country risk a critical component of the valuation of almost every large multinational corporation.
Prof. Aswath Damodaran
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