Valuing Emerging Market Equities -- A Pragmatic Approach Based on the Empirical Evidence
Journal of Applied Corporate Finance (2015)
31 Pages Posted: 8 Mar 2015
Date Written: March 6, 2015
Combining the theory with the empirical evidence, I propose a pragmatic approach to estimating the cost of equity for industry groups operating in African, Asian, and Latin American emerging markets, and high-risk European markets. My approach has two building blocks: (1) use of the U.S.-based Capital Asset Pricing Model (CAPM) with a beta that is designed to represent industry (instead of individual company) risk; and (2) an adjustment of the U.S.- based CAPM that involves assigning a certain proportion -- from as little as 35% to as much as 100% -- of a given country’s political risk to a specific industry. My empirical work finds that ADR returns are strongly correlated with: (1) S&P 500 returns where the ADR’s beta is virtually the same (statistically speaking) as the corresponding industry’s U.S.-based beta; and (2) the corresponding country’s changes in CDS spreads, capturing country risk. Moreover, I find that the coefficient in the CDS spread is strongly negatively correlated with the ADR’s P/E multiple suggesting that certain industries are more exposed to political risk than others.
Visually analyzing my empirical results, regarding country-risk exposure, I group industries into low (consumer discretionary and staples), medium (health care, industrials, information technology, materials, telecommunications, and utilities), and high-exposure categories (energy and financials). Synthesizing these results, I propose cost of equity estimations based on: (1) an industry beta, (2) the country’s CDS spread, and (3) the industry’s country-risk exposure. To cite two examples, whereas a utility operating in South Korea might have a cost of equity of less than 8%, an energy company in Russia might have a cost of equity as high as 16.25%.
Keywords: emerging market equities, cds spreads, cost of capital
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