1. International Value Creation Campbell R. Harvey Duke University and National Bureau of Economic Research DRAFT

2. International Value International Value 1. Setting A critical component in implementing EVA in international context is knowing the appropriate hurdle rates. Each country has its own risk characteristics which need to be taken into account.

3. International Value International Value 1. Setting Unfortunately, there is widespread disagreement over approaches to international valuation Different methods provide sharply different hurdle rates in international context

4. International Value International Value 1. Setting Disagreement comes at a bad time with growth in global investment

5. International Value International Value 2. Goals Motivation Defining Country Risk Methods of Calculating Hurdle Rates Implementing the International Cost of Capital Country Risk and EVA

6. International Value International Value 3. Motivation Dramatic internationalization of world –Economic integration through increased trade. –Financial integration through liberalization of capital markets

7. International Value International Value 3. Motivation (Exports+Imports)/GDP Developed Countries

8. International Value International Value 3. Motivation (Exports+Imports)/GDP Emerging Countries

9. International Value International Value 3. Motivation USD Billions Value of US Acquisitions of Foreign FirmsNumber of US Acquisitions of Foreign Firms Number Data through 1997.

10. International Value International Value 3. Motivation USD Billions Value of Foreign Acquisitions of US FirmsNumber of Foreign Acquisitions of US Firms Number Data through 1997.

11. International Value International Value 3. Motivation USD Billions Value of German Acquisitions of US FirmsNumber of German Acquisitions of US Firms Number Data through 1997.

12. International Value International Value 3. Motivation USD Billions Value of US Acquisitions of German FirmsNumber of US Acquisitions of German Firms Number Data through 1997.

13. International Value International Value 4. Motivation Advantages A broader selection of company targets Access to growth and innovation in new markets Lower operating costs – Labor – Purchased materials Reduced taxes in selected markets Reduced borrowing costs Investment incentives Reduced risk: Diversification among less correlated markets

14. International Value International Value 4. Motivation Advantages Diversification argument somewhat controversial Traditional view is that shareholders can do their own diversification. Modern view is that diversification reduces the volatility of a company’s cash flows and gives it the flexibility to pursue the most profitable projects –That is, if a company was not diversified, a negative current cash flow might exclude it from investing in high value projects (because the cost of debt and equity financing is high)

15. International Value International Value 4. Motivation Correlations of World Returns and Developed Markets Data through June 1998

16. International Value International Value 4. Motivation Correlations of World Equity Returns and Emerging Markets Data through June 1998

17. Disadvantages Increased operating cost expectations –Taxes, tariffs and quotas –Transportation/shipping costs –Infrastructure costs –Organizational costs Increased or different risk expectations –Lack of information –Different equity return premiums –Currency fluctuations –Liquidity risk –Sovereign risk (e.g. expropriation and restrictions on repatriation of capital) International Value International Value 4. Motivation

18. Investment of $100 in three Korean companies

19. International Value International Value 5. Valuation Approaches Many common methods

20. International Value International Value 5. Valuation Approaches Ratios often not comparable across countries MSCI data as of June 1998

21. DCF can be used to calculate business plan, capital investment, and acquisition values The same factors affect value around the globe – Cash flows – Timing – Risk International Value International Value 6. Global DCF Analysis

22. Value – Liquidity – Repatriation Limits – Systematic – Currency – Information – Sovereign/ Credit Risk – Currency Translation – Accounting Adjustments – Taxes Cash FlowTimingRisk Applying DCF to international opportunities requires adjustments to each component of value International Value International Value 6. Global DCF Analysis

23. Multistep process to apply DCF analysis to international opportunities Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for specific risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value Step 1Step 2Step 3Step 4Step 5 International Value International Value 6. Global DCF Analysis Calculate cash flows for international investment Reflect systematic risks

24. Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value Step 1Step 2Step 3Step 4Step 5 International Value International Value 6. Global DCF Analysis

25. Unpredictable: Hyper-Inflationary Economy Predictable: Low to Moderate Inflation Economy Forecast “real” cash flows (backout or exclude inflation) Forecast “nominal” cash flows (include inflation) Discount cash flows with the “real” economic valuation rate Discount cash flows with the “nominal” economic valuation rate International Value International Value 6. Global DCF Analysis

26. Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value Step 1Step 2Step 3Step 4Step 5 International Value International Value 6. Global DCF Analysis

27. Forecast cash flows in local currency Financial data is most often collected in local currency It has more relevance to the local management It facilitates reflecting local inflation in revenues and costs It makes calculation of taxes, repatriation limits and currency exposure easier Conversion to US dollars is easier, simpler, and less prone to error when done at the end of the local currency analysis Works best in moderate to low inflation countries International Value International Value 6. Global DCF Analysis

28. When valuing global opportunities only include cash flows that can be remitted to the parent Governments sometimes set limits on cash out flows from their countries –The amount of cash flow –The types of cash flows (e.g. dividends, profits and transfer costs) –When they can be taken out (e.g. none for five years) If repatriation is uncertain, estimate the probability of repatriation and calculate the expected value of future cash flows If delayed, cash flows should be included at the time they become available to shareholders However, if valuing for sale, include all cash flows, compute NPV, and then estimate what can be remitted International Value International Value 6. Global DCF Analysis

29. Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value Step 1Step 2Step 3Step 4Step 5 International Value International Value 6. Global DCF Analysis

30. Risk that a country's government might take actions that reduce the value of a firm to its current owners (e.g. expropriation, tax hikes) Sovereign: country credit rating Country Systematic  Devaluation/ Revaluation Risk that a drop in the value of a firm's currency will reduce the firm's value Country Systematic  LiquidityThe risk that the owners might not be able to sell assets when desired Specific  CurrencyThe risk that volatility in currency exchange rates causes a target's value to fluctuate  InflationThe risk that inflation will rise unexpectedly, reducing the present value of future international cash flows Country Systematic  Interest RateThe risk that interest rates will rise unexpectedly, reducing the present value of future international cash flows Country Systematic  InformationThe risk that limited or biased information might lead you to over value a target company Specific  International Risks Risk Description Risk TypeCash Flow Economic Valuation Rate Where to Reflect International Value International Value 6. Global DCF Analysis

31. International specific risks can be incorporated into expected cash flows using scenario analysis Steps for Scenario Analysis 1Identify risks and estimate their probabilities of occurrence 2Estimate when they are most likely to occur 3Identify the impact of each risk on expected cash flows 4Calculate expected value of cash flows by weighting the cash flows in each scenario by the probability the scenario occurs Note: The same should be done for NOPAT when calculating residual value using the perpetuity method International Value International Value 6. Global DCF Analysis

32. EXAMPLE Incorporating information, currency transaction and liquidity risks into “Global-Co’s”cash flows forecast RisksEstimated ProbabilityEstimated Cash Flow Impact Probability Adjustment Estimated Timing Currency Risk100%-10% Immediate Information (i.e. market acceptance) 20%+5%1%2 years Liquidity5%-100%-5% 3 years Risk Information Sample Cash Flow Adjustment Year 1Year 2Year 3Year 4 Base Case Cash Flows $ Millions $37$50$68$83 Currency Risk Information Liquidity -10% 0% -10% 1% 0% -10% 1% -5% -10% 1% -5% Total Adjustments-10%-9%-14% Adjusted Cash Flows ($M)$33$46$58$72 International Value International Value 6. Global DCF Analysis

33. Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value Step 1Step 2Step 3Step 4Step 5 International Value International Value 6. Global DCF Analysis

34. Future cash flows can be translated using exchange rate forecasts based on parity relationships Example: Converting Forecast Peso Cash Flows into US$ Cash Flows US$ Inflation*1.41.41.41.4 Mexican Peso Inflation*15.315.315.315.3 1 + i US$ 1 + i Peso 0.87940.77330.68010.5981 Spot US$/Peso Rate0.11770.11770.11770.1177 Forward US$/Peso Rate0.10350.09100.08010.0704 (Parity Factor x Spot Rate) Peso Cash Flows 3205007301020 US$ Cash Flows33465872 *For calculation simplicity, same inflation rates were used each year Year 1 Year 2 Year 3 Year 4 Parity Factor = International Value International Value 6. Global DCF Analysis

35. When applied correctly, forecasting in US$ or local currency results in the same shareholder value independent of the choice of currency Assumptions: US Inflation Rate 1.4% Mexican Inflation Rate15.3% US Cost of Capital10.0% Mexican Cost of Capital25.1% Spot Rate (US$/Peso)0.1177 Cash Flows Residual Value Discount Factor Present Value Cumulative PV Year 1 Year 2 Year 3 Year 4 320 5007301,020 4,067 0.79950.63920.5110 0.4086 2563203732,078 Peso 3,027 Cash Flows Residual Value Discount Factor Present Value Cumulative PV Year 1 Year 2 Year 3 Year 4 33 465872 286 0.90910.82640.75130.6830 30 3844245 $356 Forward Rates0.1035 0.09100.08010.0704 Peso Forecast US Dollar Forecast Equivalent at 0.1177 US$/Peso spot exchange rate International Value International Value 6. Global DCF Analysis

36. Cumulative PV $556 Applying today’s spot rate to the forecast grossly overstates the value if projected local inflation exceeds US inflation -- in this example by 56%! Assumptions: US Inflation Rate 1.4% Mexican Inflation Rate15.3% US Cost of Capital10.0% Mexican Cost of Capital25.1% Spot Rate (US$/Peso) 0.1177 Cash Flows Residual Value Discount Factor Present Value Year 1 Year 2 Year 3 Year 4 38 5986120 478 344965409 Cash Flows Residual Value Discount Factor Present Value Year 1 Year 2 Year 3 Year 4 33 465872 286 0.90910.82640.75130.6830 303844245 Forward Rates0.1035 0.09100.08010.0704 US Dollar Forecast (incorrectly using Today’s Spot Rate) US Dollar Forecast (using Forward Rates) Spot Rate0.1177 0.90910.82640.75130.6830 Cumulative PV $356 Cumulative PV $556Cumulative PV $356 International Value International Value 6. Global DCF Analysis

37. Forward Rates Used to bring cash flows to U.S. dollars Determined by differences in interest rates International Value International Value 6. Global DCF Analysis

38. Forward Rates Covered Interest Rate Parity is enforced by arbitrage. International Value International Value 6. Global DCF Analysis

39. Forward Rates Example. Suppose a German 12-month T-bill yield is 8% and the U.S. 12-month T-bill yield is 4%. Does it make sense for the U.S. investor to invest in the higher yielding German T-bill? International Value International Value 6. Global DCF Analysis

40. Forward Rates Answer: No If you invest in the German T-bill, you will take on some currency risk. Suppose you invested 100m DM and at the end of the year you will receive 108m DM. To hedge this risk, you will sell forward 108m DM today. The forward rate will guarantee that you lock in a 4% return - which is no different than buying the U.S. T-bill! International Value International Value 6. Global DCF Analysis

41. Forward Rates Rates are readily available for the major currencies from major banks and trading houses. Example: Bloomberg screen for $/DM International Value International Value 6. Global DCF Analysis

43. Forward Rates If no quoted forward rates: Use forward rate equation and interest rates to backout forward rates. If no quoted interest rates: Use inflation forecasts and add real economic growth forecast to create nominal interest rates. International Value International Value 6. Global DCF Analysis

44. Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value Step 1Step 2Step 3Step 4Step 5 International Value International Value 6. Global DCF Analysis

45. Many different approaches: Identical Cost of Capital (all locations) World CAPM or Multifactor Model (Sharpe-Ross) Segmented/Integrated (Bekaert-Harvey) Bayesian (Ibbotson Associates) Country Risk Rating (Erb-Harvey-Viskanta) CAPM with Skewness (Harvey-Siddique) International Value International Value 7. Economic Valuation Rate

46. Goldman-integrated sovereign yield spread model Goldman-segmented Goldman-EHV hybrid CSFB volatility ratio model CSFB-EHV hybrid International Value International Value 7. Economic Valuation Rate

47. Identical Cost of Capital Ignores the fact that shareholders require different expected returns for different risks International Value International Value 7. Economic Valuation Rate

48. Identical Cost of Capital Risky investments get evaluated with too low of a discount rate (and look better than they should) Less risky investments get evaluated with too high of a discount rate (and look worse than they are) Hence, method destroys value þAvoid International Value International Value 7. Economic Valuation Rate

49. World CAPM Sharpe’s Capital Asset Pricing Model is the mainstay of economic valuation Simple formula Intuition is that required rate of return depends on how the investment contributes to the volatility of a well diversified portfolio International Value International Value 7. Economic Valuation Rate

50. World CAPM Expected discount rate (in U.S. dollars) on investment that has average in a country = riskfree +   x world risk premium Beta is measured relative to a “world” portfolio OK for developed markets if we allow risk to change through time (Harvey 1991) International Value International Value 7. Economic Valuation Rate

51. World CAPM Strong assumptions needed Perfect market integration Mean-Variance analysis implied by utility assumptions Fails in emerging markets International Value International Value 7. Economic Valuation Rate

52. Should be a positive relation, with higher risk associated with higher return! But perhaps we should look at a more recent sample of data. International Value International Value 7. Economic Valuation Rate

53. Still goes the wrong way - even with data from 1990! International Value International Value 7. Economic Valuation Rate

54. Incorporating the Asian crisis makes the model look even worse. International Value International Value 7. Economic Valuation Rate

55. World CAPM OK to use in developed markets May give unreliable results in smaller, less liquid developed markets International Value International Value 7. Economic Valuation Rate

56. Segmented/Integrated CAPM CAPM assumes that markets are perfectly integrated –foreign investors can freely invest in the local market –local investors can freely invest outside the local market Many markets are not integrated so we need to modify the CAPM International Value International Value 7. Economic Valuation Rate

57. Segmented/Integrated CAPM Bekaert and Harvey (1995) If market integrated, world CAPM holds If market segmented, local CAPM holds If going through the process of integration, a combination of two holds International Value International Value 7. Economic Valuation Rate

58. Segmented/Integrated CAPM Estimate world beta and expected return = riskfree +   w x world risk premium Estimate local beta and expected return = local riskfree +   L x local risk premium International Value International Value 7. Economic Valuation Rate

59. Segmented/Integrated CAPM Put everything in common currency terms Add up the two components. EVR= w[world EVR] + (1-w)[local EVR] Weights, w, determined by variables that proxy for degree of integration, like size of trade sector and equity market capitalization to GDP International Value International Value 7. Economic Valuation Rate

60. Segmented/Integrated CAPM Weights are dynamic, as are the risk loadings and the risk premiums Downside: hard to implement; only appropriate for countries with equity markets Recommendation: Wait International Value International Value 7. Economic Valuation Rate

61. Ibbotson Associates (Recognized expert in cost of capital calculation) Approach recognizes that the world CAPM is not the best model Ibbotson approach combines the CAPM’s prediction with naïve prediction based on past performance. International Value International Value 7. Economic Valuation Rate

62. Ibbotson Associates STEPS 1Calculate world risk premium=U.S. risk premium divided by the beta versus the MSCI world (=7.8%) 2Estimate country beta versus world index 3Multiply this beta times world risk premium International Value International Value 7. Economic Valuation Rate

63. Ibbotson Associates 4Add in 0.5 times the ‘intercept’ from the initial regression. “This additional premium represents the compensation an investor receives for taking on the considerable risks of the emerging markets that is not explained by beta alone.” International Value International Value 7. Economic Valuation Rate

64. Ibbotson Associates Gives unreasonable results in some countries Only useful if equity markets exist Ibbotson Associates does not even use it ÙRecommendation: Do not use this version. Ibbotson is working on a better model to be available soon International Value International Value 7. Economic Valuation Rate

65. CAPM with Skewness For years, economists did not understand why people spend money on lottery tickets and horse betting The expected return is negative and the volatility is high Behavioral explanations focused on “risk loving” International Value International Value 7. Economic Valuation Rate

66. CAPM with Skewness But this is just preference for positive skewness (big positive outcomes) People like positive skewness and dislike negative skewness (downside) International Value International Value 7. Economic Valuation Rate

67. CAPM with Skewness Most are willing to pay extra for an investment that adds positive skewness (lower hurdle rate), e.g. investing in China? International Value International Value 7. Economic Valuation Rate

68. CAPM with Skewness Harvey and Siddique (1998) tests of a model that includes time-varying skewness risk Bekaert, Erb, Harvey and Viskanta detail the implications of skewness and kurtosis in emerging market stock selection International Value International Value 7. Economic Valuation Rate

69. CAPM with Skewness Model still being developed Skewness similar to many “real options” that are important in project evaluation ÙRecommendation: Wait International Value International Value 7. Economic Valuation Rate

70. Goldman-Integrated This model is widely used by McKinsey, Salomon and many others. Addresses the problem that the CAPM gives a discount rate too low. Solution: Add the sovereign yield spread International Value International Value 7. Economic Valuation Rate

71. Goldman-Integrated The sovereign yield spread is the yield on a U.S. dollar bond that a country offers versus a U.S. Treasury bond of the same maturity The spread is said to reflect “country risk” International Value International Value 7. Economic Valuation Rate

72. Goldman-Integrated STEPS Estimate market beta on the S&P 500 Beta times historical US premium Add sovereign yield spread plus the risk free International Value International Value 7. Economic Valuation Rate

73. Goldman-Integrated-EHV Hybrid Goldman model only useful if you have sovereign yield spread Use Erb, Harvey and Viskanta model to fit ratings on yield spread International Value International Value 7. Economic Valuation Rate

75. Goldman-Integrated-EHV Hybrid You just need a credit rating (available for 136 countries now) and the EHV model will deliver the sovereign yield International Value International Value 7. Economic Valuation Rate

76. Goldman-Integrated-EHV Hybrid Even adding this yield spread delivers a cost of capital that is unreasonably low in many countries While you can get the yield spread in 136 countries with the EHV method, you can only get risk premiums for those countries with equity markets International Value International Value 7. Economic Valuation Rate

77. Goldman-Segmented Main problem is the beta It is too low for many risky markets Solution: Increase the beta International Value International Value 7. Economic Valuation Rate

78. Goldman-Segmented Modified beta=standard deviation of local market return in US dollars divided by standard deviation of the US market return Beta times historical US premium Add sovereign yield spread International Value International Value 7. Economic Valuation Rate

79. Goldman-Segmented Strange formulation. The usual beta is: Using volatility ratio implies that the Correlation=1 !! International Value International Value 7. Economic Valuation Rate

80. Goldman-Segmented No economic foundation for modification No clear economic foundation for method in general ÙRecommendation: Not recommended International Value International Value 7. Economic Valuation Rate

81. CSFB E[r i ]=SY i +  i {E[r us -RF us ] x A i } x K i SY i = brady yield (use fitted from EHV)  i = the beta of a stock against a local index A i =the coefficient of variation (CV) in the local market divided by the CV of the U.S. market) where CV =  /mean. International Value International Value 7. Economic Valuation Rate

82. CSFB No economic foundation Complicated, nonintuitive and ad hoc ÙRecommendation: Avoid International Value International Value 7. Economic Valuation Rate

83. Country Risk Rating Model Erb, Harvey and Viskanta (1995) Credit rating a good ex ante measure of risk Impressive fit to data International Value International Value 7. Economic Valuation Rate

84. Country Risk Rating Model Erb, Harvey and Viskanta (1995) Explore risk surrogates: –Political Risk, –Economic Risk, –Financial Risk and –Country Credit Ratings International Value International Value 7. Economic Valuation Rate

85. Country Risk Rating Model Sources Political Risk Services’ International Country Risk Guide Institutional Investor’s Country Credit Rating Euromoney’s Country Credit Rating Moody’s S&P International Value International Value 7. Economic Valuation Rate

86. Political risk. International Country Risk Guide

87. International Value International Value 7. Economic Valuation Rate Financial risk. International Country Risk Guide

88. International Value International Value 7. Economic Valuation Rate Economic risk. International Country Risk Guide

89. International Value International Value 7. Economic Valuation Rate International Country Risk Guide Risk Categories

90. International Value International Value 7. Economic Valuation Rate Institutional Investor’s Country Credit Ratings

91. International Value International Value 7. Economic Valuation Rate Ratings are correlated:

92. International Value International Value 7. Economic Valuation Rate Ratings are correlated:

93. International Value International Value 7. Economic Valuation Rate Ratings are correlated:

94. International Value International Value 7. Economic Valuation Rate Ratings are correlated:

95. International Value International Value 7. Economic Valuation Rate ICRG ratings predict changes in II ratings:

96. International Value International Value 7. Economic Valuation Rate Ratings predict inflation:

97. International Value International Value 7. Economic Valuation Rate Ratings correlated with wealth:

98. International Value International Value 7. Economic Valuation Rate Time-series of ratings:

99. International Value International Value 7. Economic Valuation Rate Fit is as good as it gets - lower rating (higher risk) commands higher expected returns. Even in among US firms, our best model gets about 30% explanatory power.

100. International Value International Value 7. Economic Valuation Rate Even with the turbulent Asian crisis returns, we still get an impressive fit.

101. Credit Rating Model Intuitive Can be used in 136 countries, that is, in countries without equity markets Fits developed and emerging markets International Value International Value 7. Economic Valuation Rate

102. Country Risk Rating Model STEPS: EVR = risk free + 0.944 - 0.177 Log(IICCR) Where Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating International Value International Value 7. Economic Valuation Rate

103. Easy to use:

104. International Value International Value 7. Economic Valuation Rate Also predicts volatility:

105. International Value International Value 7. Economic Valuation Rate Fitted volatility:

106. International Value International Value 7. Economic Valuation Rate And correlation.

107. International Value International Value 7. Economic Valuation Rate Fitted correlation.

108. International Value International Value 7. Economic Valuation Rate Asian Crisis.

109. International Value International Value 7. Economic Valuation Rate Asian Crisis. Beginning of crisis

110. International Value International Value 7. Economic Valuation Rate Value of US$100 Beginning of crisis

111. International Value International Value 7. Economic Valuation Rate Value of local currency (indexed at 100) Beginning of crisis

112. International Value International Value 8. Comparison of EVRs 68%

113. 537% International Value International Value 8. Comparison of EVRs

114. Estimated Equity Risk Premia: Country Risk Models IICCR: Institutional Investor Country Credit Rating ICRGC: International Country Risk Guide Composite Rating See Table 2 for details.

115. Estimated Bond Risk Premia: Country Risk Models IICCR: Institutional Investor Country Credit Rating ICRGC: International Country Risk Guide Composite Rating See Table 2 for details.

116. Java Version International Value International Value 8. Comparison of EVRs

117. Excel version International Value International Value 8. Comparison of EVRs