We thank participants at the Research in Management Seminar at IAE Business School in Buenos Aires in September 2007, and at the BALAS Conference in Bogota, in May 2008.
Valuation in Emerging Markets: A Simulation Approach
Article first published online: 23 JUL 2010
Copyright © 2010 Morgan Stanley
Journal of Applied Corporate Finance
Volume 22, Issue 2, pages 100–108, Spring 2010
How to Cite
García-Sánchez, J., Preve, L. and Sarria-Allende, V. (2010), Valuation in Emerging Markets: A Simulation Approach. Journal of Applied Corporate Finance, 22: 100–108. doi: 10.1111/j.1745-6622.2010.00279.x
- Issue published online: 23 JUL 2010
- Article first published online: 23 JUL 2010
Most of the foundations of valuation theory have been designed for use in developed markets. Because of the greater, and in some cases different, risks associated with emerging markets (although recent experience might suggest otherwise), investors and corporate managers are often uncomfortable using traditional methods. The typical way of capturing emerging-market risks is to increase the discount rate in the standard valuation model. But, as the authors argue, such adjustments have the effect of undermining some of the basic assumptions of the CAPM-based discounted cash flow model.
The standard theory of capital budgeting suggests that estimates of unconditional expected cash flows should be discounted at CAPM discount rates (or betas) that reflect only “systematic,” or “nondiversifiable,” market-wide risks. In practice, however, analysts tend to take what are really estimates of “conditional” expected cash flows—that is, conditional on the firm or its country avoiding a crisis—and discount them at higher rates that reflect not only systematic risks, but diversifiable risks that typically involve a higher probability of crisis-driven costs of default. But there is almost no basis in theory for the size of the increases in discount rates.
In this article, the authors propose that analysts in emerging markets avoid this discount rate problem by using simulation techniques to capture emerging-market risks in their estimates of unconditional expected cash flows—in other words, estimates that directly incorporate the possibility of an emerging-market crisis and its consequences. Having produced such estimates, analysts can then discount them using the standard Global CAPM.