Valuation Across Currency Borders – Special Considerations

When valuing companies across currency borders, especially in emerging markets, one needs to factor in special considerations regarding, inter alia, exchange rates, cost of capital, political risk, tax rates and inflation. As an example, below look at relevant aspects of conducting a DCF analysis for a Serbian company.

DCF In Different Currencies

In principle, there are two ways to value a company across currency borders:

„ Value cash flows in home terms (e.g. Euros) according to this approach:

§ Convert the Serbian dinar (CSD) flows to €, using the forecast of forward CSD/€ x-rate

§ Then discount the € cash flows using the €-based WACC that reflects not only the systematic risk of the industry and local equity market, but also the political risk of the country (further discussed later in the chapter)

This approach assumes that purchasing power parity (PPP) and interest rate parity (IRP) hold8

„ Value cash flows in foreign terms (e.g. CSD) according to this approach:

§ Discount the dinar flows using the Serbian cost of capital. Importantly, if discounting dinar flows, it is necessary to base the WACC’s risk-free rate on the dinar-denominated bonds

§ Then translate the dinar DCF into € using the spot rate

This approach assumes that the availability, and quality, of foreign capital market data is good (which is not always the case).

Tax Rates

When applying tax rates to the cash flow, take into consideration the local tax regime:

„ Use the marginal tax rate of the foreign country if the buyer resides in a country that is part of a territorial tax system in which the buyer’s country exempts foreign income from further taxation (about half of the OECD countries use a territorial tax system)

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Terminal value in the example is calculated using a Gordon Growth Formula: dividends = earnings – retention = (ROE – growth rate) * net asset value. Thus, a terminal value = net asset value * (ROE – growth rate) / (Cost of Equity – growth rate).

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PPP asserts that €/CSD exchange rate will be based on the purchasing power of the two currencies: x-rate will tend toward 85 if 85 CSD buys in Serbia the same bundle of goods as 1€ in the Euro-area). IRP asserts that the difference between the spot and forward x-rates is equal to the difference between interest rates prevailing in the money markets for lending/borrowing in the respective currencies: SPOTCSD/€ / FWDCSD/€ = (1+Return€) / (1+ReturnCSD).

„ Use the higher of the buyer’s or target’s country tax rate if the buyer resides in a country that is part of a worldwide tax credit system (e.g. the US) in which the buyer’s country recognises taxes paid in a foreign country as a credit against tax liability at home

Consistency

In the complex maze of multi-currency valuation in emerging markets a couple of important consistency rules should be observed:

„ The same tax rate should be assumed in estimating the after-tax cash flows, the levered beta, the WACC and the debt tax shields

„ Assuming that both revenue and costs are derived from the same currency base, the same inflation rate should be used for revenues, costs, working capital, Capex, risk-free rate, interest rates and Forex rates

2.6.

How to Interpret the Results

Interpretation of the results of a DCF valuation requires the selection of a valuation range. A DCF matrix provides a range of Enterprise Values corresponding to a range of assumptions regarding the cost of capital and the terminal multiple / terminal growth. Deciding which valuation range is suggested by the analysis is not a mechanical exercise but requires judgement.

Ask the following key questions:

„ Does the valuation, based on the terminal multiple method and the terminal growth method, provide broadly consistent valuation results? If the values derived by applying both methods are vastly different, question whether:

§ The chosen range of multiples and growth rates is consistent; in particular, double check the reasoning behind the chosen terminal multiples to ensure they are appropriate for the business in a steady state

§ The terminal year EBITDA margin and unlevered FCF are truly normalised

„ Are the implied entry multiples consistent with the assumed / implied exit multiples? If there is a material difference, an explanation should be provided. In particular, beware of situations where the exit multiple is significantly above the implied entry multiple. Provide reasons why the business will trade at a higher multiple in the future than the multiple implied by the DCF analysis

Further, to ensure that the range selected is meaningful, try not to exceed a range of 15 – 20% unless justified by significant uncertainty.

DCF analyses implicitly assume access to cash flows and management decisions and as such implicitly include a control premium. As a consequence, DCF analysis is considered to be at a premium to market value which a rational investor would ascribe to individual shares in the company.

It is, therefore, not only vital to understand the DCF analysis itself but also how it fits into the overall valuation exercise. To avoid inappropriate conclusions, which could arise from simply using the DCF analysis for valuation, it is important to apply other valuation techniques in conjunction with DCF analysis, for example Compco and Compacq analysis. Note that DCF valuation results typically range closer to valuation results obtained through Compacq analyses and above values suggested by Compco analysis.

3.

Helpful Hints

3.1.

Sense-Checking Results

A DCF analysis is only as good as the assumptions going into the model. Furthermore, errors in the mechanics of the model may render the results entirely meaningless. It is, therefore, imperative to sense check the results. Ideally, use a printout of the model and a calculator, rather than the Excel model itself.

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Key checks to keep in mind include:

„ Unlevered FCF

§ Make sure the numbers add up, i.e. all line items are included in the total and are added or subtracted in line with their impact on cash flow (e.g. D&A is added, not subtracted, change in net working capital is cash flow positive when net working capital decreases)

§ Reconcile the unlevered FCF with the change in cash. Any line item not included in the unlevered FCF calculation which is included in the change in cash calculation needs to be explainable, i.e. needs to be captured in the EV adjustments (e.g. interest and debt repayments are excluded from unlevered FCF since DCF is an Enterprise Value concept and Net Debt is treated as an EV adjustment)

„ Use a calculator to cross check the discounting of FCFs and Terminal Value

„ Ensure all appropriate adjustments have been made to derive Equity Value from Enterprise Value, paying special attention to minorities, pensions, etc.

„ Look at key ratios to ensure the model makes sense:

§ Consolidated revenue growth

§ Consolidated margins

§ Relationship of Capex and D&A and development of asset turn over the projection period

§ Composition of the resulting Enterprise Value (i.e. percentage accounted for by Terminal Value)

§ Implied Enterprise Value multiples at entry (i.e. what multiple of EBITDA, EBIT does the DCF- derived Enterprise Value represent?). If there is a large deviation from sector trading / transaction multiples, try to understand why

§ ROCE in final year / normalised year

„ Terminal Value

§ Terminal Value must be consistent with the strategy assumed during the explicit forecasting period. For example, if the asset base was run down during forecast period, Terminal Value should reflect state of facilities

§ Use normalised results as the basis for the Terminal Value calculation. Ratios should be evaluated and adjusted, if necessary (e.g. depreciation relative to capex, required capex level, EBITDA margin, change in net working capital, tax rate)

§ Avoid using multiples implying high growth for which the market might be prepared to pay today. At the end of the explicit forecast period assume normalized growth of the business

§ Always check how much the Terminal Value contributes to total Enterprise Value. The higher the proportion, typically the less meaningful the valuation (obviously depends on planning horizon)

„ Value drivers

§ Focus on what is driving value. Five key value drivers are typically more important than 15 low- impact variables

3.2.

Surviving the MDR/DIR/VP “Grilling”

DCF models become complex quite quickly and it is easy to forget all the assumptions / decisions made as the model has been developed. A few easy measures will help address any challenging questions on the model:

„ Structure the model in a clean, clear fashion which provides for a clear separation of inputs and outputs so that causes and effects are easily separable and understandable

§ Keep in mind, MDRs dislike models which are not easily printable in their entirety

„ Never mix assumptions and formulas, i.e. do not hardcode within formula cells

„ Prepare an assumptions summary and a structured collection of back-ups to the assumptions while building the model

„ Test how it reacts to changes in key drivers and be ready to explain why it reacts in such fashion

„ Keep the model simple as clients prefer clarity to complexity

4.

Example

The following example demonstrates the mechanics and key steps of a DCF. The task is to perform a DCF valuation on ChocoFriends, a Swiss-based niche premium chocolate manufacturer.