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Investment Valuation in

Developed and Emerging

A Comparative Study
Priyanshu Bhattacharya

Tutor: Simon Brillouet

" When any real progress is made, we unlearn and learn anew what we thought we knew before “
- Henry Dav id Thoreau
Investment Valuation in Developed and Emerging Economies


Investment valuation in itself is a complex process, and when it comes to

valuing companies in emerging markets things can get very ambiguous. Past
research has shown that emerging markets are very different from developed
markets in terms of macroeconomic environment, structure of financial
markets, information environment, etc. This study takes a look at the
contemporary problems that one face while valuing a company in an
emerging market environment. Through this research I have found that the
depth of financial markets in emerging countries has increased in past one
decade. Correlation between equity returns of developed and emerging
markets have improved, suggesting a movement from segmented to a global
market environment. Inflation and exchange rate volatility are still an
ongoing concern. I have utilized the above results of my analysis to
amalgamate them in to a coherent framework to address the process of
investment valuation in emerging market.

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1. Introduction .................................................................................................................................... 7
1.1 Motivation for this research: ........................................................................................................ 7
1.2 Research Idea:............................................................................................................................... 8
1.3 Research Questions for Theoretical Part, Empirical and Qualitative Part................................... 9
1.4 Data and Research Design for Empirical and Qualitative study: ............................................... 11
1.5 Structure of the thesis:....................................................................................................... 13
2. Defining Emerging Markets: ........................................................................................................ 14
2.1. The World Bank Definition of Emerging Market:............................................................................ 14
2.2. MSCI Barra: .................................................................................................................................. 14
2.4. History of Emergence: .................................................................................................................. 15
2.5. The process of emergence: ........................................................................................................... 16
3. Literature Review: ....................................................................................................................... 19
3.1 Asset Pricing: Emerging Markets, CK Harvey(2000): ........................................................................ 19
3.2 Research in Emerging Market Finance,...................................................................................... 21
3.3 Incorporating Country Risk in the Valuation of Offshore Projects, Donald R Lessard(1996): ............. 23
3.4 Investment Opportunities as Real Options: .................................................................................... 25
4. Country Risk Analysis in Emerging Markets: ............................................................................. 27
4.1 Risk Profiling in Emerging Markets ............................................................................................. 27
5. Macroeconomic Analyses: ............................................................................................................ 30
5.1 GDP, Growth and Financial Depth: .......................................................................................... 30
5.2 Inflation in Emerging Markets: .................................................................................................. 36
5.3. Interest Rates in Emerging Markets:.............................................................................................. 40
5.4 Exchange Rates and Financial Crisis in Emerging Markets: ...................................................... 42
5.5 Probit Analysis for Emerging Countries:.................................................................................... 44
6. Importance of valuation in emerging markets: ............................................................................. 48
6.1 Green Field Projects....................................................................................................................... 51
6.2 Mergers and Acquisitions in Emerging Markets: ....................................................................... 52
6.3 Private Equity Investments in Emerging Markets:..................................................................... 53
6.4 Global Portfolio Investments: .................................................................................................... 55
7 The process of valuation: ............................................................................................................... 56
7.1 Relative Valuation in Emerging Countries:................................................................................ 57
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7.2 DCF Valuation: .......................................................................................................................... 64
7.2.1 Steps in a DCF Valuation Process:.......................................................................................... 65
7.3 Asset Pricing Models: ................................................................................................................. 67
7.3.1 The Capital Asset Pricing Model: ................................................................................................. 67
7.3.2 The International CAPM or the Global CAPM Model: ................................................................... 70
7.3.3 The Godfrey and Espinosa Model: ............................................................................................... 71
7.3.4 The Credit Model:....................................................................................................................... 72
7.4 Capital Market Analysis of Emerging Countries: ...................................................................... 74
7.4.1 Correlation between local and global markets: ............................................................................ 74
7.4.2 Capital Access:......................................................................................................................... 78
7.4.3 Market Liquidity: ........................................................................................................................ 80
7.3.4 Concentration of Companies in Stock Exchange: .......................................................................... 82
7.3.5. Transparency:............................................................................................................................ 83
7.3.6. Market Efficiency:...................................................................................................................... 83
7.3.7. Stock Market Synchronicity:....................................................................................................... 84
7.3.8 Financial Information Score Card................................................................................................. 86
7.4. Risk-Free Rate: ............................................................................................................................. 88
7.5. Equity Risk Premiums in Emerging Markets:.................................................................................. 94
7.6. Betas:........................................................................................................................................... 96
7.6.1. Country Beta: .......................................................................................................................... 100
7.7. Adjusting for Company Specific Risk:........................................................................................... 100
7.7.1. Size Effect:............................................................................................................................... 101
7.7.2. Control Premium and Illiquidity Discounts:............................................................................... 101
7.8. Tackling Inflation in Emerging Markets:....................................................................................... 101
7.9. Applying Simulation to Valuation of Emerging markets: .............................................................. 103
8. Survey of Valuation Process in Emerging Markets: ......................................................................... 105
9. Conclusion: ................................................................................................................................... 113
10. Research Implications and the road ahead…................................................................................. 114
References........................................................................................................................................ 115

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List of Figures
Figure 1: Diagram showing the change in Economic Integration in the last 4 decades............................. 17
Figure 2: Diagram showing the different risks and how they interact in a business environment ............. 27
Figure 3: The GDP share of the world as of 2009 ................................................................................... 30
Figure 4: GDP growth in last 3 decades .................................................................................................. 31
Figure 5: Classification of Developed and Emerging Markets based on Market Cap and GDP ............... 32
Figure 6: Comparison of a few Emerging Markets based on Market Cap as a % of GDP ........................ 33
Figure 7: A measure of globalization based on comparison of Trade and FDI as a % of GDP ................. 34
Figure 8: A measure of financial depth in developed and emerging market ............................................. 35
Figure 9: A measure of inflation in emerging markets ............................................................................ 37
Figure 10: A measure of inflation in developed markets ......................................................................... 37
Figure 11: Measure of inflation expectation in Emerging Countries (2010) ............................................. 39
Figure 12: Measure of real interest rates in Emerging Countries (2010) and 5 years average ................... 40
Figure 13: Comparison of Average Fixed Investments in Emerging Countries ........................................ 41
Figure 14: Comparison of Average Fixed Investments in Emerging Countries ........................................ 42
Figure 15: The Standardized Coefficients of the Probit Model ................................................................ 45
Figure 16: The impact of economic variables in classifying a country as an emerging Market ................ 46
Figure 17: The "Spaghetti bowl" of IIAs ................................................................................................ 48
Figure 18: Comparision FDI by volume and growth in developed and emerging nations in the last two
decades .................................................................................................................................................. 50
Figure 19: Volume of M&A in emerging nations in the last two decades ................................................ 52
Figure 20: PE Investments as a % of GDP in a few countries ................................................................. 54
Figure 21: A general va luation model ..................................................................................................... 57
Figure 22: Factors affecting the asset pricing model ............................................................................... 73
Figure 23: Correlation between emerging market returns and world returns (1990-99) ........................... 75
Figure 24: Correlation between emerging market returns and world returns (2000 -10) ........................... 75
Figure 25: Stock Market turnover ratio (2009)........................................................................................ 81
Figure 26: Sovereign Defaults in the Emerging Countries....................................................................... 89
Figure 27: Bond Yields in different developed countries ........................................................................ 90
Figure 28: Framework showing the calculation of riskfree rate in emerging markets .............................. 94
Figure 29: Framework for calculating beta in emerging markets ............................................................. 99
Figure 30: Survey Answers on Valuation Methodology ........................................................................ 105
Figure 31: Survey answers on level of comfortability on valuation ....................................................... 106
Figure 32: Survey Results on Cost of Capital ....................................................................................... 107
Figure 33: Survey Results on Cost of Capital (2) .................................................................................. 108
Figure 34: Survey Results on Cost of Capital (3) .................................................................................. 108
Figure 35: Survey Results on calculation of cost of equity .................................................................... 109
Figure 36: Survey Result on Riskfree rate ............................................................................................ 110
Figure 37: Survey Results on Riskfree rates ......................................................................................... 110
Figure 38: Survey Results on Calcluation of Inflation........................................................................... 111
Figure 39: Survey results on difficulty levl of valuation. ....................................................................... 112

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List of Tables:
Table 1: Developed Nations according to MSCI Classification ................................................................... 14
Table 2: Emerging Nations according to MSCI Classification .................................................................... 15
Table 3: Taxonomy of risks that can be used for profiling before valuation ................................................. 28
Table 4: Recent Macroeconomic Parameters of Emerging Countries........................................................... 32
Table 5: GDP Deflators as a measure of Inflation in Emerging Markets ...................................................... 38
Table 6: Classification of Multiples based on Value Drivers of a Company ................................................. 58
Table 7: Table showing the 5 years average of Major Macroeconomic Variables of Emerging Countries ...... 62
Table 8: Pearson's Correlation Coefficients between Major World Index..................................................... 76
Table 9: Pearson Correlation Coefficient between developed and emerging countries .................................. 77
Table 10: Score Card of Emerging Markets for evaluating market integration.............................................. 79
Table 11: Market Liquidity of Emerging Markets ...................................................................................... 80
Table 12: Table Showing the comparison of contribution of top 10 companies in the stock exchange............ 83
Table 13: The transparency index score of emerging countries ................................................................... 83
Table 14: Market Efficiency Studies in Emerging Markets ......................................................................... 84
Table 15: Stock Price Synchronicity ......................................................................................................... 85
Table 16: Riskfree rates of emerging countries calculated by three different methods................................... 93
Table 17: Historical Equity Risk Premim Calcluated by three different methods .......................................... 95
Table 18: Adjustment of Inflation based on real and nominal approach ..................................................... 102

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1. Introduction
1.1 Motivation for this research:
In his book Capitalism, Socialism and Democracy, Schumpeter describes the
process of creative destruction where he says “The fundamental impulse that sets
and keeps the capitalist engine in motion comes from the new consumers’ goods, the
new methods of production or transporta tion, the new markets, the new forms of
industrial organization, that capitalist enterprise creates. . . . The opening up of new
markets, foreign or domestic, and the organizational development from the craft shop
and it illustrate the same process of industrial mutation—if I may use that biological
term—that incessantly revolutionizes the economic structure from within, incessantly
destroying the old one, incessantly creating a new one. This process of Creative
Destruction is the essential fact about capitalism. . . . Every piece of business
stra tegy acquires its true significance only against the background of that process
and within the situation created by it. It must be seen in its role in the perennial gale
of creative destruction” 1 . The above passage describes the very essence of
globalization and the institutional, organizational and technological changes the
world is currently experiencing. Although globalization has been taking place ove r
several centuries but the last two decade has seen this phenomenon occurring at
an unprecedented magnitude. After the Second World War the world was divided
in two camps with different ideologies regarding the development and upliftment of
its people. On one hand the free market model which focused on free trade and on
the other hand there was the centrally planned economies – where the state
decided on the products to manufacture, production capacity, export/imports, etc.
During the early nineties many centrally planned economies collapsed which lead
to the integration of these countries into the global economic system. This process
added around 1 billion new workers to the global workforce, which lead to rapid
industrialization and transformed many countries from agrarian to manufacturing
and services based economies.

The purpose of this piece of work is to explore the emerging markets and the
process of valuation that is practiced in these countries. Emerging Markets cover
70 percent of the world population and adds up to 30 percent of world GDP. There
is huge promise and growth potential for companies evolving from emerging
markets. The advent of new technologies, reduction in transportation cost, cheap
labor, rapid industrialization and quick absorption of high technical knowledge
has created a dynamic socio-economic environment for the emerging countries.
Industrialization has fomented the rapid rise of the middle class in emerging
countries. Rise in income per capita in emerging countries will promote a surge in
demand for high value added goods, services. The huge inflow of investments in
these countries is a standing proof of this fact. According to projections by

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Goldman Sachs, China is bound to take over USA in 2020 in terms of real GDP.
Brazil, India, Russia will be bigger than many European economies2.

The opening up of the financial markets in majority of these countries took place
in the past two decades. The first decade was an era of consolidation and
restructuring when financial markets were introduced, capital controls were
slackened and government controlled assets and companies were opened up for
privatization. The second decade has seen astounding amount of returns in
emerging equity markets, which in turn have increased investor expectations.
Empirical Research conducted in the field of emerging markets shows imperfect
and segmented capital markets which provides equal amount of opportunities of
risk and reward for investors. The two basic incentives: a promise of higher returns
and second the benefits of portfolio diversification saw a huge influx of investments
in emerging countries. This artificially bloated the asset prices in EM‟s which was
way above their intrinsic value. The irrational exuberance or the herd effect on the
part of the investors created a series of crisis in the 90‟s. Right from the Mexican
crisis to the Russian Crisis saw destruction of wealth which brought out one fact
to the forefront: the ability to capture the risk associated emerging countries in
the investment decision process is of prime importance for investors and
multinationals alike, so asset valuation is an important concern in emerging

1.2 Research Idea:

The main objective of this thesis is to explore the valuation practices in emerging
markets and how the diverse viewpoint of academics and practitioners regarding
the valuation in emerging markets can be tied together into a coherent framework
and to bring out the contrast in practices with that of developed markets, but
within the boundaries of major economic theory. To achieve this goal, I intend to
break down my main research objective into auxiliary objectives and research
questions. I further divide my research questions into three different parts: the
theoretical part and the empirical part and the qualitative part. I believe that this
process will help me to approach the whole research in a holistic way.

Based on the premises of traditional valuation models and their strengths,

weaknesses and assumptions, I try to raise a few important questions for the
theoretical construction of emerging market valuation. When I try to answer these
questions I found that many of the related research were conducted almost a
decade ago. Given the dynamic nature of emerging markets and the rapid
globalization I feel that testing the assumptions of traditional asset valuation

http://www2 -decade-doc.pdf
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theories can do much better to consolidate the process of valuation in eme rging
markets, which brings me to my second part of the research questions which are
related to empirical research. Through my empirical research I wish to validate the
valuation theories related to emerging markets using relevant economic and
market data. The third part of the thesis, i.e. the qualitative parts is a general
survey about the process of valuation where I intend to study about the
convergence and divergence of real world practitioners with that of what theory
and empirical evidence has to offer.

1.3 Research Questions for Theoretical Part, Empirical and Qualitative Part
In this part of the thesis I want to research the asset pricing models and what are
the steps that are followed in a standard valuation process in general, irrespective
of it being a developed market company or an emerging market company.

 Research Question 1: What are the key issues in valuation process in

emerging markets

To answer this question we need to understand how the emerging countries

different from that of the developed countries. In this part I will study the history
of emergence, distinguish a emerging country from that of a developed country. I
intend to study the economic environment of emerging markets and how do they
differ from that of the developed markets. To get a broad overview of the issues I
would like to look into the different forms of investments that are taking place in
emerging markets and the issues faced by foreign companies when valuing
investments in emerging markets.

 Research Question 2: What are the standard valuation models that academics,
practitioners use, what are their strengths and limitations

To study the valuation of companies in emerging economies, it is very important

for us to know about the standard asset pricing models that are currently used for
valuation in developed markets. For this I, intend to carry out a detail literature
review and study the past empirical research that has been performed in this field.
From here I will go on to study about the asset pricing theories in emerging
markets. From the above mentioned studies I want to pick up the assumptions
related to emerging markets and verify them in my empirical study.

 Research Question 3: What are the most important criteria for the selection of
valuation model in emerging markets

To answer this question I have to explore the different areas where valuations are
used in emerging markets environment (e.g. Greenfield, M&A, private equity,

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portfolio investments). This will provide me with a broad overview of the current
practices and the issues faced in valuation. After this I wish to study the
macroeconomic environment and the different aspects of financial markets in
emerging markets. From this analysis i will try to deduce the influence of the
macroeconomic environment on the financial markets in emerging countries and
how they in turn affect the valuation of a company.

 Research Question 4: How we need to adjust cashflows in emerging

 Research Question 5: What are the problems with standard capital pricing
model of calculating cost of equity in an emerging market environment?
 Research Question 6: What are the alternative methods to calculate the cost of
equity that are available to the standard capital asset pricing model in
emerging markets
 Research Question 7: How do we choose the correct cost of equity for the
emerging market environment?

While trying to answer the above question for the theoretical part I had to verify
many of the above theories for the emerging market environment. This brings me
to the quantitative part of my thesis. Through this part I wish to tackle the
following questions

 Research Question 1: How do you classify emerging markets from that of

frontier markets and developed markets?

The process of emergence is not a stationery process. Countries which are frontier
markets today will become emerging in the coming few years. So through this
question I try to find out if there is any methodological process by which we can
identify the degree of emergence of a frontier country so that we can apply the
developed frameworks. To achieve this goal I would first try to identify the
economic variables that play an important role in classifying markets into different
categories. After this classification I would like to use the econometric tool, Probi t
Regression to analyze the probability of a country falling within the defined group
of variables. Through this method we can get a brief overview of a process to
classifying a country into the emerging market dimension.

 Research Question 2: Previous research had shown that emerging markets are
not tha t highly correlated so benefits of portfolio diversification can be
obtained by investing in emerging markets. So how do the world markets
behave presently?

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I hypothesize the fact that emerging markets have achieved greater correlation in
the past one decade and are more integrated to the global markets due to the
furious pace of globalization. To answer this question I intend to use the Pearson‟s
correlation coefficient test for stock markets around the world to see how they are
correlated now.

 Research Question 3: How to the emerging market stands at present in terms

of market efficiency, market liquidity, and stock price synchronicity?

To answer this question I intend to collect the data from different e merging stock
exchanges and bind them together in a score card based methodology to get a
ranking order for emerging markets.

The third part of my research is the qualitative research part of my thesis. Through
this part I would prepare a questionnaire that I will be sending out to academics,
students and practitioners to study what they feel about emerging market
valuation. Questions related to valuation methodology, cost of capital and
availability of data will be raised. Due to the time constraint that this has, the
questionnaire part has been restricted to a size of just 10 questions to increase the
effectiveness of the survey.

1.4 Data and Research Design for Empirical and Qualitative study:
The data analysis and empirical research throughout this paper is an important
ingredient of this thesis. The data sources in this paper can be classified into two
categories, primary data source and secondary data source. The primary data
source has been classified into two parts

1. Data for the empirical research and data analysis: This data constitute time
series data of emerging countries regarding macroeconomic environment,
stock market data, Country P/E ratios and company data. The main source
of data are World Bank data series, Emerging Market Database offere d by
Compustat, Data from Bloomberg and national stock exchanges of different
emerging countries.
2. The primary data source for qualitative part of the research is the survey
results as submitted by students, academics and professionals.

My source of secondary data has been research papers of different authors who
have already conducted similar kind of research in this area.

In every empirical research, a proper descent research methodology with the

correct choice of data is very important. Throughout my empirical research I have
followed the research methodology framework suggested by (Cohrane, pg-5, 2005).

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1. It must address the underlying research problem properly
2. It must be within a existing research area so that the results can be
compared easily
3. The method should be as simple as possible.

For the empirical research I have used simple econometrics tools (Wooldridge,2002)
such as simple regression analysis, cross-sectional regression analysis, logistic
regression along with other statistical tools such as Pearson Correlation analysis of
time series data. Using these tools, I wish to test the fundamental assumptions of
the asset pricing models in the emerging market environment and compare them
how they stand against previous research conducted in this area.

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1.5 Structure of the thesis:

Introduction of the

Defining Emerging
Markets and the
process of Emergence

Literature Review

Country Risk and


Application of valuation in
Emerging Countries,
identification of issues,
constraints, scope.

Analysis of the Valuation

Process and the factors
influencing valuation in
emerging markets

Valuation Survey

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2. Defining Emerging Markets:

The term emerging market was coined by World Bank economist Antoine van
Agtmael to describe those countries that have adopted market reforms and are in a
transition phase from developing to developed nations. There are many global
institutions and bodies that classify countries on various parameters. It is very
important to look at the various definitions and parameters on which these
classifications are made, as these economic fundamentals are very important for
the framework for valuation.

2.1. The World Bank Definition of Emerging Market:

The world bank defines economies on the basis of Gross National Product(GNP) per
capita. According to World Bank data source countries are classified as low income,
middle income (subdivided into lower middle and upper middle), or high income 3.
All countries that are not developed are classified as emerging countries by World-
Bank. The income per capita is an important measure to classify a country but
there should be other parameters that should be taken into account while
investment decisions are made. According to the latest data available there are 27
Developed Economies and rest Emerging Economies

2.2. MSCI Barra:

MSCI is a leading provider of investment decision support tools to investors
globally. The MSCI maintains different market indices and it classifies countries
into developed, emerging, and frontier economies. The criteria for classification are
Economic Development, Size and Liquidity Requirement and Accessibility of

According to MSCI Global standard indices there are 24 Developed Countries, 21

Emerging Markets and 31 Frontier Markets4. The classification of countries done
by MSCI is more focused in terms of scope of investments and factors influencing
an investment decision.

List of Developed Nations (MSCI)

Australia Cyprus Germany Ireland Luxembourg Portugal Switzerland
Austria Denmark Greece Israel Netherlands Singapore United Kingdom
Belgium Finland Hong Kong Italy New Zealand Spain United States
Canada France Iceland Japan Norway Sweden
Table 1: Developed Nations according to MSCI Classification

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List of Emerging Markets

Brazil Czech Republic Indonesia Peru South Africa Turkey
Chile Egypt Malaysia Philippines South Korea
China Hungary Mexico Poland Taiwan
Colombia India Morocco Russia Thailand
Table 2: Emerging Nations according to MSCI Classification2.3. S&P IFC Emerging Market

As similar classification as MSCI is available with S&P IFC Emerging Market Index.
According to the S&P IFC methodology
“Country classification depends on a range of factors covering macroeconomic
conditions, political stability, legal property rights and procedures, and trading and
settlement processes and conditions. Further, the opinions and experiences of
institutional investors matter. If most institutional investors see major risks in a
market and treat it as a frontier or emerging market, no amount of analysis by index
providers will turn it into a developed market. The institutional consensus is critically
important” 5.

2.4. History of Emergence:

Six major events can be identified that influenced the history of emergence in the
past fifty years under three broad categories institutional, technological, and

1. The polarization of the world under two economic principles, the

planned economy and the free market economy: The polarization of the
world under two economic principles had a profound implication on the
emerging countries. The Second World War had left many of the countries
totally ravaged, and many of the above mentioned emerging economies
undertook the socialist form of development to address the problem of
poverty, education, unemployment. Corrupt regimes, dictators, and
unethical practices in many of these economies didn‟t help the cause of
development either. The growth was very slow and general conditions of
people didn‟t improve much. On the other hand the free -market model
thrived and it transformed many of the poor nations within a short period of
2. The Bretton W oods fixed currency system: With the implementation of
the Bretton Woods system, most currencies were pegged to the dollar which
made the dollar a valuable commodity (at par with gold) and most currencies
were not convertible and so there was a restriction on international
investments. Although the bretton woods brought exchange rate stability for

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many nations, it also restricted free flow of capital and convertibility was a
major issue.
3. The success of countries like Japan, Taiwan, Singapore under the free-
market economy : Huge trade liberalization of the Japanese and
Taiwanese economy saw their country flooded with investments which also
helped local companies to become more competitive and efficient and thus in
the process bolstered the economy. This event was important learning point
for many of the countries which faced stagnant economic growth due the
trade restrictions.
4. China’s economic reforms: When in 1978, China embraced Găigé kāifàng
(Reform and Opening) it meant only one thing, an evitable death of the
socialist economy. The revolutionary steps taken to address the economic
stagnation and worsening conditions of the Chinese people had a far
fetching impact in today‟s globalized world.
5. The collapse of USSR: The collapse of the USSR in 1991 liberated many of
the countries in the soviet block and was free to choose their own
government. This also meant that many countries that were under the
influence of Russia, now had to accept reforms to integrate itself with the
world economy e.g. India. The beginning of the 1990‟s turns out to be a
major paradigm shift for many emerging market economies, so I will base all
my empirical studies from the starting of 1990‟s.
6. The globalization of the world with path-breaking technological
advancements: The rapid development of technology and its decreasing
cost meant that many of the less developed countries were connected like
never before. In the last two decades the world has seen a drastic fall in high
distance transportation cost(both in manufactured goods and services).This
development reduced trade barriers drastically and encouraged production
of goods and services to places with cheap labor cost. As Krugman (1995)
classify this global economic situation as „increasing return to scale’ which
means as the country increases in size it becomes more efficient.

2.5. The process of emergence:

Looking at all emerging countries, we can say there is a definite roadmap on the
process of a countries emergence. The process of emergence generally starts with
the liberalization of the economy which means that countries remove restrictions
on trade barriers, large scale privatization of government undertakings, and
creating the right environment to foster growth.

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Change in EFW Index In Last 4 Decades


Percentage Change




-5.00 1970-80 1980-90 1990-00 2000-07



EM Markets USA UK

Figure 1: Diagram showing the change in Economic Integration in the last 4 decades

(Source: Created from the data set available from Fraser Institute)

Freedom of the world by Fraser Institute 6 has been tracking the Economic
Freedom of the world on various parameters and publishes an index every year. To
provide evidence on the process of emergence I looked at the average change in the
index of the emerging markets in comparison to USA and UK. The period of 1990-
00 saw the greatest economic freedom embraced by these countries.

Emergence of a market has a very high correlation with the amount of

globalization that a country undergoes. Although there is no direct measure of the
amount of globalization that a country undergoes as globalization has both
tangible and intangible components attached to it. But, according to KOF, an
organization that publishes a globalization index lists the following economic
factors which influences globalization and hence emergence of an economy7

Economic Flows:

 Trade (percent of GDP)

 Foreign Direct Investment flows (percent of GDP)
 Foreign Direct Investment, stocks (percent of GDP)
 Portfolio Investment (percent of GDP)
 Income Payments to Foreign Nationals (percent of GDP)

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Economic Restrictions:

 Hidden Import Barriers

 Mean Tariff Rate
 Taxes on International Trade (percent of current revenue)
 Capital Account Restrictions

The rate of globalization can affect an emerging market in many ways. With
globalization the cost of equity capital should decrease . Stultz (1995) argues that
with globalization the expected returns on the risk that investors bears falls and
agency costs that make more expensive for companies to raise capital diminishes.

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3. Literature Review:
Much has been said and written in the field of emerging market finance, but due to
the dynamic environment of emerging markets many of the theories have been
challenged but nonetheless the huge amount of work conducted in this filed has
helped us understand the emerging markets better. I have conducted literature
review on some seminal work done in the field of emerging market finance as well
as in the field of corporate finance. The main aim of my literature review is to
delimit my research problem, gain insights on methodological procedure and to
seek support on the implemented finance theories which are applied to emerging
market countries.

The structure of the literature that i have conducted is based on the following

1. To analyse the research outcomes

2. The methodology used for analysis
3. The basic finance and economic theories that are discussed

After reviewing of each paper i would like to provide my own views and critical
analysis of the literature reviewed.

3.1 Asset Pricing: Emerging Markets, CK Harvey(2000): In this paper

(Harvey,2000) discuss the asset pricing methodologies employed in developed
countries and how they differ from that of emerging countries. This paper is
organized towards developing a conceptual framework of asset pricing rather than
taking a quantitative or econometric approach. It provides the intuition behind
asset pricing and the development that have taken place in this area.

The goal of the paper is to take a conflict resolution approach where the author
tries to address the different conflicts that arise in asset pricing in emerging
markets. The highlights of the research outcome of this study are

1. The Capital Asset Pricing Model developed by Sharpe(1964), Lintner(1965)

fails to address asset pricing in emerging markets
2. The correlation between developed market returns and emerging market
returns are very low as emerging markets have a very different industrial
composition compared to that of developed markets

The central theory that is used in the whole paper is the Capital Asset Pricing
Model and Markowitz Portfolio Theory. (Harvey,2000) argues that the basic
premise of asset pricing theories remain the same all throughout: investors like
higher return than lower expected return, investors are risk averse and they hold

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an universe of well diversified portfolio. The main problem with applying the asset
pricing models like the CAPM is that the assumptions under which the model
operates was based on a de veloped market environment. These assumptions are
very unrealistic for emerging market environment. The main assumptions of the
CAPM like investors are only concerned about mean and variance, asset returns
are multivariate normally distributed, perfect capital markets, zero transaction
costs. Among all these assumptions the one that weakens the CAPM most is the
assumption of perfect capital markets. When the CAPM is applied to an emerging
market then it assumes that emerging markets are perfectly integrated with the
world economy which in turns means that the same risk asset commands the
same expected return irrespective of the location of the asset. For the above
assumption to hold true there must be no barriers to portfolio investments across
borders. The author argues that this premise doesn‟t hold true for emerging
countries as there is restriction in capital inflows and outflows in emerging

According to (Harvey,2000), the problem arises in emerging markets is due to its

transitionary nature, as the markets cant neither be considered as full integrated
or completely segmented. This creates the problem of applying the Global CAPM or
the segmented CAPM in emerging markets. So the author takes an alternative
approach and supports the use of a dual model proposed by Bekaert and Harvey
(1995).In the own words of the author “This framework explicitly recognizes that
the integration process is gradual. Bekaert and Harvey parameterize and estimate
a model that allows for a time varying market integration. In the polar case of
market integration, their model reduces to the world capital asset pricing model. In
the case of market segmentation, their model reduces to a local CAPM. In the
partial integration world, the expected rate of return is a weighting of world
covariance times world price of covariance risk and the local volatility and the
reward for the local volatility. To make the model dynamic, this weighting changes
through time. The model assumes that the weighting is function of two variables
that proxy for the openness of the market: the size of the trade sector and the
capitalization of the local equity market.”

The other important point that the author stresses in this paper is the importance
of correlation in a diversified portfolio. In portfolio theory it states that if a high
variance asset is added to the portfolio which has zero or negative correlation with
that of the expected return of an asset then the high variance asset reduces the
overall variance of the portfolio. (Harvey,2000) states that emerging market
returns have very low correlation with that developed markets as the set of
industries in emerging markets is different from that of a developed market.

Brief review of the paper: The paper gives a good introduction to the asset pricing
model in emerging economies but it limits itself only to the CAPM and the adjusted
CAPM model. The problem with the alternative proposal is that it reduces the
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integration process as a function of two variables that proxy for the openness of
the market: the size of the trade sector and the capitalization of the local equity
market. Here it is very difficult to agree with the author because of the following
reason: In countries like India which has huge market capitalization and huge
number of companies listed, but around 80% of the market capitalization is
contributed by the top 100 companies (while the number of listed companies in the
stock exchange is above 4500). This creates a strong misconception regarding
market integration and market capitalization of stock market.

Second, it is very difficult to agree with the fact that returns of emerging market
returns don‟t have significant correlation with world markets. Factors such as
globalization, regional trade agreement and financial policies pursued by developed
nations do have an impact on the correlation of returns in emerging markets e.g. It
has been observed that how financial policies like quantitative easing funnels
money in emerging markets and artificially pushes up asset prices.

3.2 Research in Emerging Market Finance, (Bekaert, Harvey, 2002): Looking

into the future (Bekaert, Harvey, 2002) is a study about the issues and research
areas in emerging market finance. This paper was a very obvious choice as it
explores a wide range of factors in emerging market finance on whose basis the
asset valuation in emerging market depends. The organization of the paper is
conceptual, as it focuses on the factors and parameters which affect investment
decision in emerging markets. The paper starts off by identifying the key issues
with the financial environment of emerging markets. According to (Bekaert, Harvey,

1. Market Segmentation
2. Market Integration
3. Market Volatility
4. Distribution of returns in emerging markets
5. Efficiency of emerging markets

are the major factors which influence investments in emerging markets.

The outcome of their research is very interesting and has a major influence in my
research topic. (Bekaert, Harvey, 2002) identifies two different categories of
barriers to emerging market investments: Legal Barriers or indirect barriers, these
types of barriers arises due to information asymmetry, accounting standards,
investors protection and the other kind of barriers are liquidity risk, economic
policy risk, political risk, currency risk. These are the barriers that create market
segmentation and delay the process of proper market integration. The second
outcome of the study is that volatility doesn‟t have any influence upon the
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integration process. They analyzed the annualized volatility of returns for emerging
countries with a split point at 1990. According to their findings there in no pattern
whatsoever among the emerging market nations that could prove that integration
helps to decrease volatility of returns.

Many theories of finance are based on the assumption that market returns are
normally distributed but research conducted by (Bekaert, Harvey, 2002) shows
that emerging market returns are not normally distributed. The emerging market
returns are skewed and have fat tails and this has a very big impact on the
traditional risk models like CAPM used in emerging markets. Efficiency of
emerging markets is another area where (Bekaert, Harvey, 2002) casts se rious
doubts. They have found that emerging market equity returns have higher
correlation than developed market returns (also known as price synchronicity)
which is related to infrequency of trading and slow reflection of market information
on stock prices.

The research method used by (Bekaert, Harvey, 2002) is to use historical data of
emerging markets to carry out the analysis. International financial corporation
have the equity market returns of emerging markets of almost 40 years. They have
based their research on historical time series analysis. (Bekaert, Harvey, 2002)
have broken down the analysis into two periods one before the 1990‟s and the
other from 1990-2000. To date the integration of capital markets in emerging
economies they have used the

1. Regulatory reform dates of the emerging countries

2. The date of the first country fund
3. The date of first equity listing of an emerging market company in a foreign
exchange firm
4. Improvement in degree of investor protection and significant changes in
accounting standards.

The methods of analysis employed are quantitative analysis where statistical

concepts such as standard de viation of returns, correlation analysis, regression
analysis, skewness, kurtosis are used derive the results.

Financial theories such as the traditional Capital Asset Pricing Model is discussed
and so are concepts like market integration, stock market volatility, market
efficiency and their impact on the traditional asset pricing model . (Bekaert, Harvey,
2002) goes on to give a brief overview of the basic relationship. In the words of the
author “A simple intuition can be gained from looking at asset prices in the context
of the Sharpe (1964) and Lintner (1965) capital asset pricing model (CAPM). In a
completely segmented market, assets will be priced off the local market return. The

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local expected return is a product of the local beta times the local market risk
premium. Given the high volatility of local returns, it is likely that
the local expected return is high. In the integrated capital market, the expected
return is determined by the beta with respect to the world market portfolio
multiplied by the world risk premium. It is likely that this expected return is much
lower. Hence, in the transition from a segmented to an integrated market, prices
should rise and expected returns should decrease” The above paragraph in the
paper captures the theoretical essence on which the author have based their whole
research regarding emerging markets.

A brief critical review of the paper: As I have already mentioned that the emerging
market is a very dynamic environment so this study is almost like a static
photographic study where we are giving the developments till a particular frame of
time. The paper acts as a good base for anyone looking to carry out research on
emerging market finance. It acts as a guide book for areas which we need to watch
out for while researching on emerging market finance.
The level of analysis accomplished in this paper is through simple statistical
analysis and there has been gross assumptions regarding lots of minute issues
from which conclusion are drawn. One area that I felt that the paper didn‟t touch
was the influence of macroeconomic environment on emrging market returns.

3.3 Incorporating Country Risk in the Valuation of Offshore Projects, Donald R

Lessard(1996): In this paper Lessard(1996), describes a framework to incorporate
country risk in the valuation of offshore projects. The organization of the above
paper is conceptual where an argumentative approach is used to address the issue
of country risk in emerging markets. Through this work Lessard(1996), identifies
the problem of assigning arbitrary risk adjustment techniques to the discount
rates to value projects in emerging markets. According to the author, these kind of
adjustments does not reflect the correct information about either the nature of the
risks or about the ability of management to manage such risks. This approach has
great impact on project selection in emerging markets as higher discount rates
reduce the attractiveness of a project and it also reduces a firm‟s ability to align
strategic and financial actions through risk identification and elimination.

The methodology that is employed in this paper is to de velop a taxonomy of the

risks that is relevant in emerging markets and then the author provides a
framework how can companies allocate this risk to different agents and create
value through strategic risk taking. Then the author suggests ways to incorporate
country risk in the valuation process. The data used by the author for analysis are
International Country risk Guide data on emerging countries.

The main research outcomes of this paper are:

1. In valuation of projects in emerging markets, managers and companies
should focus on risk allocation rather than risk elimination. This target can

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be achieved to through tailored structuring of projects and financial
2. Risk in default of government bond‟s can be used as a proxy for political and
country risks such as threat of expropriation, government policies regarding
industries and sectors.
3. Factoring in the unfamiliar environment of emerging countries in the
discount rate is a wrong approach, since with passing time the environment
of an emerging market is better understood and unfamiliarity should
decrease rather than compounded as done when adjustments are made in
the discount rate.
4. Indentifies five classes of factors that will affect the free cash flows, discount
rates and the resulting present value of projects in emerging countries
- Market and competitive factors
- Currency Factors
- Tax factors
- Differences in Market Covariance Risk
- Downside country risk factors

The most important outcome of this paper that I feel is highly relevant to my work
is the taxonomy of risk developed by the author to address the risk environment in
emerging markets. According to Lessard(1996), the major risks that companies
faces while investing in emerging markets can be classified as
- World market price risk
- Macroeconomic and Political Risk
- Country level price risk
- Institutional regulatory risk
- Project and commercial risk

Operator/Strategic Local Strategic Local Portfolio Local Public Int' portfolio International
Investor Investor Investor Authority Investor Policy Lender


Contract Enforcement

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Exchange Rate
World Market
Oil Prices
Interest Rates

Before any investment in emerging market the author suggest following the above
framework to analyze the risks that a company faces and how those risked can be
addressed. In this way a company can increase its comparative advantage and
mange the risk that could have ended up as an addition of a fudge factor to the
discount rate of the project.

Review of the paper: This paper acts as a practical guide about the risks that one
faces in emerging markets. It briefly discusses the topics of country risks,
operational risks and how should they be treated in the valuation process. The
rationale of adjusting cash flows to reflect the majority of the risks as compared to
the adjustments of the discount rate is a highly attractive proposition. It gives the
valuator lots of space to analyze the investment under different scenarios and
macroeconomic conditions.

3.4 Investment Opportunities as Real Options: Getting Started on the Numbers

(Luehrman, 1998): This paper discusses the application of options valuation to
investments. The main goal of this paper is to bring out the difference between
traditional DCF valuation and Real Options Valuation and how to apply the
techniques of real option valuation. (Luehrman, 1998) tries the bridge the gap
between the practicalities of real-world capital projects and options pricing theory.

The author develops a seven step framework to identify and value real options.
The methodology described is as follows:
1. To recognize the option and describe it: The first step involves recognizing
the embedded option. The option can be a growth option or an option to
delay, or abandon.
2. The mapping stage: In this step (Luehrman, 1998) maps the five variables
that are used to price options with that of the real option situation that is
embedded in the investment process. The first step lies in identification and
mapping of the process

Investment Opportunity Variable Call Option

Present Value of projects S Stock Price
operating cost to be acquired
Expenditure required to acquire X Exercise Price
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the the project assets
Length of time the decision may t Time to Expiration
be deferred
Time Value of Money rf Risk free rate of return
Riskiness of Project Assets σ2 Variance of returns on stock

3. The third step involves to separate the embedded option from the DCF
calculation into two parts, and two identify S and X in the problem.
(Luehrman, 1998) suggests that the key to this process is to differentiate
between discretionary costs Vs non discretionary cost and to separate
routine vs extraordinary cost. After the costs have been classified the DCF
evalauation is broken down in two phases
4. In this step, a benchmark for the real option analysis is setup by using the
rearranged DCF analysis

This paper is to establish the mapping between the five variables used in options
pricing and the real life option embedded in an investment. As many investments
in emerging markets tend to be risky so many situation can be modeled in the
form of real options. What is controversial is the application of concepts of the
Black Scholes formula in an emerging market setting.

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4. Country Risk Analysis in Emerging Markets:

The general perception about emerging markets is that they tend to be highly risky
when compared to that of a developed market. It is very important to profile these
risks in emerging markets and there should a proper framework for addressing
this risk in the valuation of emerging market companies.

Market Systemic

Domestic Global

Economic Environment

Physical Climate
Resources Country
Environmental Political
Operational Legal/regulatory
Market Opportunities

Business Risk
– sourcing
– production
Operational –
– selling
people Company
– competition
Industry risk

Figure 2: Diagram showing the different risks and how they interact in a business environment

(Source: Adopted from Risk Management in Emerging Markets)

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The above diagram (Olson,pg-53,2002) gives a whole array of risk that a company
might face when operating in an emerging market. Every company wants to earn
rewards by taking some amount of risk and this is accomplished through thorough
assessments of the market opportunities at hand. The risk that a company faces
can come from different sources. The chart below collates all the risk and the
definition of each risk is provided.

Taxonomy of Risk faced by a Company

Type of Risk Defintions of Risk

the risk of failing to achieve business targets due to
inappropriate strategies, inadequate resources or
Business risk changes in the economic or competitive environment.

the risk that a counterparty may not pay amounts

Credit risk owed when they fall due
the credit risk associated with lending to the government
itself or a party guaranteed by the government (not to be
Sovereign risk confused with country risk).
the risk of loss due to changes in market prices. This includes
– interest rate risk
– foreign exchange risk– commodity price risk
– share price risk
(it does not mean risk of falling demand in economic
Market risk markets which is part of business risk).
the risk that amounts due for payment cannot be paid due
Liquidity risk to a lack of available funds.
the risk of loss due to actions on or by people, processes,
infrastructure or technology or similar which have an
Operational risk operational impact including fraudulent activities
the risk that financial records do not accurately reflect
Accounting risk the financial position of an organization
the risk that a foreign currency will not be available to allow
payments due to be paid because of a lack of foreign
Country risk currency or the government rationing what is available.
the risk that there will be a change in the political
Political risk framework of the country
Industry risk the risk associated with operating in a particular industry.
the risk that an organization may suffer loss as a result of
environmental damage caused by themselves or others
Environmental risk which impacts on their business
the risk of non-compliance with legal or regulatory
Legal/regulatory risk requirements
the risk that a small event will produce unexpected
consequences in local, regional or global systems not
Systemic risk obviously connected with the source of the disturbance
Table 3: Taxonomy of risks that can be used for profiling before valuation

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Among all the risk stated above risk that will affect the valuation of any companies
in emerging markets are

 Sovereign Risk
 Country Risk
 Political Risk
 Legal and Regulatory Risk
 Market Risk

Many of the above risks arise from the macroeconomic and political environment of
a country. The valuation process is highly influenced by a large number of
uncertain variables and forecasting of e vents and parameters is highly crucial part
of the investment decision process.

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5. Macroeconomic Analyses:
The purpose of the macroeconomic analysis is an important part of this thesis.
Through macroeconomic analysis I want to study the economic performance of the
emerging countries over a period of time. This analysis is intended to highlight the
strengths and weaknesses of emerging countries when compared to a developed
nation. It will also help us to highlight the key economic parameters that directly
or indirectly affect the valuation in emerging market environment.

5.1 GDP, Growth and Financial Depth: GDP of a country is defined as the final
value of all goods and services that is produced in a country. The GDP constitutes
of four important parts

- Personal consumption expenditures

- Gross private domestic investments
- Net exports
- Government consumption expenditure.

The GDP of a country has a very important impact on the financial markets
whether it be stocks bonds or currency of a country. Although the GDP is a lagging
indicator, it acts as a barometer reading about the performance of a country. It
provides important insights about a countries growth prospect, sector performance
and corporate profits. To get a broad overview about the country performance, I
analyzed the times series data available with World Bank for the last three decades.
As of 2009 the World GDP stands at 61 trillion dollars with 65.5% coming from
developed markets (the list above), 25.2 % from emerging markets and the rest 9.3%
from the rest of the world. In the past two decades the world GDP grew at an
average of 3.5%, the developed countries at 3.1% and the emerging economies
grew at 6 percent.


25.24% GDP Contribution in 2009


Developed Markets Emerging Markets Frontier Markets

Figure 3: The GDP share of the world as of 2009

(Source: Created from World Bank Data Source)

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Average Yearly GDP Growth in last 3 decades

Growth %

1980-90 1990-00 2000-09
World GDP Growth Developed Markets BRICS Emerging Nations

Figure 4: GDP growth in last 3 decades

(Source: World Bank Data Source)

The GDP of emerging markets have been growing at a steady rate of 6 %for the last
one decade and within this the major contributors are the BRICS economy. A
sustained strong GDP growth is good for the economy, companies and stock
valuation. The strong growth in GDP leads to an increase in price of goods and
services, which in the form of inflation can have a major impact on the growth. The
difference between the GDP and GNI of the emerging economies is a positive
upward slope for the past 10 years which confirms the fact that EM‟s are major
recipient of investments from developed world.

Country Cap GDP Market GNP/Capita
(in Bn$) (in
2009 Bn$)2009 Cap/GDP 2009
Brazil 1337.72 1268.51 1.05 7300
Chile 230.73 135.77 1.70 9370
China 5010.66 4832.99 1.04 2940
Colombia 140.52 198.46 0.71 4620
Czech Republic 54.48 172.29 0.32 16650
Egypt, Arab
Rep. 91.09 188.06 0.48 1800
Hungary 30.33 125.88 0.24 12810
India 1226.68 1185.73 1.03 1040
Indonesia 196.66 468.39 0.42 1880
Korea, Rep. of 836.46 727.11 1.15 21530
M alaysia 263.36 212.48 1.24 7250
M exico 352.05 827.19 0.43 9990
M orocco 64.48 84.65 0.76 2520
Philippines 82.55 156.44 0.53 1890

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Poland 147.18 402.97 0.37 11730
Federation 861.42 1163.65 0.74 9660
Singapore 0.00 176.54 0.00 34760
South Africa 805.17 243.32 3.31 5820
Thailand 142.25 268.58 0.53 3670
Turkey 234.00 552.18 0.42 9020
Table 4: Recent Macroeconomic Parameters of Emerging Countries

In-terms of GNP/capita, the Emerging Markets countries are the one which falls
under the low, lower-middle, or upper- middle income category. The stark
difference with that of the developed economies in terms of income level provides
very strong incentive of cost advantages and scope of industrial development.

According to both MSCI and S&P IFC Emerging Markets, the criterion to classify a
developed market from an emerging market takes the following facts into account –
the income level, market depth and GDP to differentiate it from the frontier and
other markets. This contrast is sharply captured when we plot the Market Cap
/GDP ratio vs the GNP/ capita for both emerging and developed countries. In
terms of Market Cap/GDP, ratio there is not much difference between the
developed countries and the emerging markets but the difference is highlighted in
case of GNP/capita of both emerging developed nations.

Classification Of Developed and Emerging Economies on

Basis of GNI/Capita and Market Cap to GDP Ratio
90000 Emerging Countries
80000 Dev Market

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50
Market Cap/GDP Ratio

Figure 5: Classification of Developed and Emerging Markets based on Market Cap and GDP

(Source: Created from World Bank Time Series Data)

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The market cap of the emerging countries grew at a rate of astounding triple figure
rate for many emerging countries in the last two decades. A few of the emerging
countries touched 6000%. The main reason being appropriation of untapped value
which was not accessible due to absence of market based economy and due to the
tsunami of privatization that took place in the 90‟s.

Market Cap as a % of GDP


Market Cap as % of GDP





90 91 92 93 94 95 96 97 98 99 0 1 2 3 4 5 6 7 8

Brazil China India Russian Federation South Africa

Figure 6: Comparison of a few Emerging Markets based on Market Cap as a % of GDP

(Source: Created from World Bank Time Series Data)

The Market Cap as a % of GDP is in an important indicator of the overall valuation

of the market. The graph above shows how the relative markets cap has increased
for the emerging economies. The growth of all the major emerging economies is
almost similar in the past 20 years. The historical average for this indicator in
developed world has been around 70 percent. A strong correlation has been found
between very high Market cap as a % of GDP and recession 8 . During the tech
bubble the developed markets reported an average of 135%. This is often
attributed to overvaluation of the economy as a whole. In the above graph we see
that the emerging markets are equally affected. The market cap of emerging
markets took a plunge from 177% to 80% of GDP. This raises a vital question
about the diversification benefits of international investors who wants to have
emerging markets stocks in their portfolio. The outlier in the above graph is South

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Africa which always had very well established commodities trading market and
solid financial institutions. Another reason that can be attributed to the high
market capitalization in emerging markets is the policy of low interest rates that
has been practiced in the west over the last decade. This allows investors to
indulge in practices such as carry trades, which has considerable effect on market

Relative Growth in FDI and Trade as a % of GDP

Growth in FDI as a % of GDP(1995-2009)

30.00 Emerging Countries

25.00 Devloped Countries

South Africa India

20.00 Russia


Spain USA
5.00 UK
Australia China Germany
-1.00 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00
-5.00 Mexico
Czech Republic Brazil
Growth in Trade as a % of GDP (1995-2009)

Figure 7: A measure of globalization based on comparison of Trade and FDI as a % of GDP

(Source: Created from World Bank Time Series Data)

The above graph shows a plot of the Growth of FDI as a % of GDP to that of
Growth in Cross Border Trade as a % of GDP. The plot shows how rapidly
countries like Russia, South Africa, India and Hungary been embracing
globalization. The relative positions of the developed economies suggests a stable
growth rate over a longer period time barring Germany which has in the last
decade established itself as an export powerhouse. When it comes to emerging
economies there is a high variance among the countries. Long terms data might
have provided a different picture all together. But the main aspect of this is to
bring out the fact these variances is due to the different growth cycle periods in
different countries, change in government outlook and policy. Previous studies
have shown the strong correlation between level of trade and FDI‟s with that of
asset valuation. This random nature of growth in different emerging countries can
provide international investors the benefits of diversification.
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Another important measure that I looked at was the depth of the emerging markets
when compared to that of developed markets. Financial depth of a market is
defined as the ratio of total financial assets to that of the GDP of a country.
Greater financial depth is highly desirable for a countries economic growth.
Greater financial depth provides more liquidity, makes capital access much easier,
increases market efficiency and provides opportunity of risk diversification. As of
2010, I plotted the financial depth of emerging and developed countries against the

Comparision of Financial Depth in Developed and Emerging

1600 Markets
Financial Assets as a % of GDP

1000 Singapore
800 South Korea
CanadaUnited States
600 Germany Australia
Hungary China
400India Thailand Czech Republic Austria
Phillipines Brazil Mexico
Indonesia Colombia Turkey Russia
3,000.00 GDP/Capita(Logarithimic Scale) 30,000.00

Figure 8: A measure of financial depth in developed and emerging market

(Source: Created from time series data available from EIU Country Data)

When compared to the 1990, the financial depth in many of the emerging
countries has increased by more than 200 percent (average). Almost all emerging
countries have decent financial depth and a few of them (like Singapore, South
Korea) are at par with that of developed nations. When we break down the
financial assets of a country into basic components we get equities, private debt,
government debt and deposits. So a high increase in financial assets means that
there is drastic rise in the issuance of equities. Slowly more and more countries
are looking at other options of financing (Corporate Bonds, Asset Backed
Securities). From the valuation point of view, we can say that rising asset prices in
emerging markets also affect the financial depth of the company.

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5.2 Inflation in Emerging Markets: Inflation is defined as the % rate of change of a
price index. Inflation in itself has great impact on asset valuation. Research has
shown how fixed income assets shed value in a highly inflationary environment.
With stocks it has been argued that it acts as a hedge against inflation but In
recent times the perception, that any company which can grow at the rate of or
above inflation can successfully negate the effect of inflation has been challenged
as the rise in cost of capital in real terms and mark down of net asset value that
are in nominal terms along with the inability to achieve the growth due to loss in
sales volumes can have a far reaching consequences on a company9.

The study of inflationary environment is very important in emerging countries

where factors like (Mishkin, 2004)

a. Weak fiscal institutions

b. Low credibility of monetary institutions
c. Vulnerability to capital inflows
d. Government supervision and regulation (like subsidies, and price controls)

To study the inflationary environment in emerging economies, I analyzed the data

for both emerging and developed nations for the past 20 years. There are many
indicators for measuring inflation e.g. consumer price index (CPI), producer price
index, GDP deflator, etc. To analyze and compare inflation in emerging economies I
preferred the GDP deflator over the other indicators as it is a implicit measure that
is derived from the national account as ratio of GDP to current price s to constant
prices. The whole range of economic activity is covered by this measure when
compared to CPI or PPI where the measure is against a particular basket of objects
and price indices are often skewed by delay in data collection and manipulation.

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Inflation in Emerging Markets Brazil

65 China
45 Republic
GDP Deflator %

15 Mexico

5 Russian













South Africa

Year (1990-2008)

Figure 9: A measure of inflation in emerging markets

(Source: Created from time series data available with World Bank)

8 Inflation in Developed Markets

7 Australia
GDP Deflator %

3 Germany














Years (1990-2000)

Figure 10: A measure of inflation in developed markets

(Source: Created from time series data available with World Bank)

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GDP Defl ators in Developed and Emerging Markets
Countries Arithmetic Geometric Standard Highest Lowest
Mean Mean Devi ation Value Value
Australia 2.80 2.12 1.57 5.53 0.06
Austria 1.86 1.19 1.06 3.78 0.00
Belgiu m 2.05 1.80 0.90 3.99 0.35
Brazil 451.18 34.14 875.90 2735.49 3.73
Canada 2.24 1.77 1.14 4.13 0.06
Chile 8.24 5.69 6.41 22.46 0.23
China 5.92 4.89 5.62 20.61 -1.25
Colo mb ia 16.27 13.33 10.64 45.36 4.75
Czech Republic 8.08 4.36 9.06 36.19 0.00
Den mark 2.13 1.98 0.81 4.26 0.67
Egypt, Arab Rep. 8.90 7.13 5.18 19.73 0.87
France 1.77 1.47 0.68 2.64 0.05
Germany 1.57 1.24 1.41 4.96 -0.68
Hong Kong SAR, Ch ina 2.04 4.53 5.10 9.93 -6.15
Hungary 14.02 10.76 9.58 35.72 2.28
Ireland 3.00 3.13 2.07 6.61 -1.20
Japan -0.27 0.52 1.35 2.94 -1.73
Korea, Rep. o f 4.73 4.46 3.16 10.66 -0.14
Morocco 3.23 2.35 3.20 12.16 -0.60
Norway 4.00 4.29 4.29 15.65 -1.77
Philippines 7.55 6.98 3.19 16.53 2.93
Poland 14.69 7.59 16.93 55.23 0.00
Portugal 4.88 4.12 3.33 13.14 1.91
Russian Federation 173.55 44.82 378.66 1490.42 13.85
South Africa 9.45 8.92 3.29 15.73 4.61
Spain 4.21 4.00 1.43 7.33 2.38
Sweden 2.55 1.79 2.42 8.98 0.23
Switzerland 1.41 0.97 1.42 5.43 -0.13
Thailand 3.64 3.51 2.70 9.24 -4.04
Turkey 52.74 37.67 36.16 137.96 6.22
United Kingdom 3.04 2.77 1.57 7.73 1.19
United States 2.36 2.26 0.72 3.87 1.11
Devel oped Countries 2.68 2.45 2.09 7.24 -0.28
Emerging Markets 50.03 13.32 86.41 2735.49 -4.04
Table 5: GDP Deflators as a measure of Inflation in Emerging Markets

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The time series of the GDP Deflator in emerging markets shows the
unpredictability of inflation in the emerging markets. In countrie s like Russia,
Brazil inflation at times had touched 3 digit figures. In developed nations the
average inflation has hovered around 2.45 percent in the past twenty years with a
standard deviation of 2.09 as compared with emerging markets where the
geometric mean of inflation for the past twenty years has been around 13.32
percent with a standard deviation of 86.41 percent which shows the
unpredictability of the emerging markets when it comes to inflation. Research
conducted about the high inflation environment in emerging markets has been
attributed to weak financial institution, lack of inflation targeting which causes
huge variance in inflation expectations and the gap between investment and
growth where investment lags the growth.

This unpredictable environment creates problem regarding adjustments in real

and nominal cash-flows regarding taxes, working capital, capital expenditure
forecasting. Different methods have been studied to incorporate the process of
inflation in the capital budgeting process. There have been arguments in favor of
inclusion of the inflation in the discount rate (Van Horne, 1971)while others have
pitched for adjustments in the capital budgeting process. So for any valuation
purpose in emerging market it is very important to anticipate the future
inflationary environment. The one way to anticipate the inflationary environment is
to study the rate of money supply relative to the GDP growth (Clark, Pg-64, 2002).

Change in Money Supply with GDP Growth

Annual Change in Money Supply

1.5 Turkey
1 South Africa
0.5 Russia Indonesia
0 India
Poland Mexico
-1 -0.5 1 3 5 7 Thailand 9 China 11

-1 GDP Growth

Figure 11: Measure of inflation expectation in Emerging Countries (2010)

(Source: Created from time series data available with EIU)

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In the figure countries like Brazil, Turkey, Morocco can face future inflationary
pressure. As suggested by (Clark, Pg-64, 2002) another way to look at the future
inflationary condition is to look at the ratio of government budget deficit to that of
GDP Growth as it is commonly perceived that budget deficit needs to be filled up
by supplying more money into the system.

5.3. Interest Rates in Emerging Markets:

Real Interest Rates


Present Interest Rates

5 Years Average
5 Years Average Interest Rate in EM : 7.1%

Figure 12: Measure of real interest rates in Emerging Countries (2010) and 5 years average

(Source: Created from time series data available with EIU)

Interest Rates influence major economic decisions in a country. It can be

considered as a double edged sword which can have both good and bad effects on
the economy. The 5 years average interest rates in emerging countries have been
around 7%. As the figure shows that the recent interest rates in emerging
countries have been the lowest. This comparatively low interest rate can be
attributed to the recent global economic downturn. For businesses it is desirable to
have a lower interest rate, as it lowers the cost of capital and provides incentive for
business to invest more. This in turn boosts aggregate demand of a country. Lower
interest rates in emerging markets can reduce issues like Carry Trade and avoid
the possibility of asset bubbles. As interest rates become low, people move away
from plain bank deposits to equities and other alternative asset investments which
will in turn increases the liquidity and depth of financial markets.

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The major issue with lower interest rates in emerging markets is the fact that it
can cause inflation to rise in leaps and bound. As inflation targeting measures are
not that strong in emerging countries so reduced interest rates might act as a
future problem (as already seen in many emerging countries).

Average Fixed Investments in the past 5 year (%growth)

Emerging Countries Developed Countries

-2.5 -10.2 NORWAY
-3.1 -16.9 GREECE
-5 0 5 10 15 20 -20 -15 -10 -5 0 5 10 15

Figure 13: Comparison of Average Fixed Investments in Emerging Countries

(Source: Created from time series data available with EIU)

The interest rate of a country is also influenced by the Investment demand in that
country. A surge in investment demand in a country can put upward pressure on
the interest rate. I studied the average fixed investments in both developed and
emerging markets in the past 5 years. The average growth rate of fixed investments
in emerging markets has been a double digit figure in the past 5 years while that
in the developed world has been going down consistently. The other important

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factor that needs to be considered is the very slow decline in the savings rate in
emerging markets. If this is the case on the long run then there will be a widening
gap between the demand and supply of capital which will see a rise in the interest
rates in emerging countries.

From the above analysis, it is highly likely that interest rates will become more in
the coming years, so will a company‟s cost of capital. Many companies might seek
alternate source of capital compared to traditional banks to fund their investments,
to stay competitive. From valuation point of view a proper frame work must be in
place to determine the cost of capital in an emerging market environment.

5.3 Exchange Rates and Financial Crisis in Emerging Markets:

Typically, emerging market countries are associated with high exchange rate
volatility. The high volatility can have adverse effect on the variance on the value of
monetary and real assets and liabilities and operating income of a firm (Giddy,Pg -
6.8,2001). Exchange rates also have strong implication on a country‟s economic
condition and have strong analytical implication on the investment decision
making process in emerging markets. I calculated the 10 years annual historical
volatility of exchange rates of emerging countries.

10 Years of Historical Volatility in EM's

17.49 18.14 19.14

14.01 14.54 15.35
12.22 13.02 13.80
8.24 9.60
5.80 6.17 7.14

Figure 14: Comparison of Average Fixed Investments in Emerging Countries

(Source: Created from time series data available with EIU)

Almost 60% of countries in emerging markets have volatility of above 10%. This
high rate of volatility arises from many of the country‟s macroeconomic
fundamental (e.g. current account deficit, budget deficit, inflationary environment,
and interest rate fluctuations).
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Most of the countries in emerging markets with high volatility in exchange rate
have faced devaluation issues in the past 20 years. According to (Homifar, pg-21,
2004) current account deficit (the difference in income between a countries exports
and imports) is an important metrics which can act as an indicator of a countries
future exchange rate environment. If a country increases its import of capital (in
terms of goods, services and credit) to fuel its current consumption instead of
future consumption then interest rates and foreign exchange risk can have a
devastating effect on a country. Many emerging countries like Mexico(1994), Asian
Tiger Economies(1997), Russia(1998), Brazil(1999) have faced the devaluation of
currency due to a sustained current account deficit.

According to (Homaifar,2003) the currency crisis in many of the emerging

economies had similar traits. The promise of high returns from emerging markets
leads to a huge flight of capital from international investors. The imbalances in
current account were financed with the cheap inflow of capitals and short term
credit by international banks. This encouraged local corporations to borrow heavily,
without proper regulation. As political uncertainty struck these countries,
investors pulled money out of these countries which resulted in severe devaluation
of currency. Due to currency devaluation many countries employ capital control to
restrict the flight of capital out of a country to mitigate the effect of currency
devaluation. For this reason exchange rate risk is an important part of the country
risk analysis and proper measures should be taken to integrate this in the
valuation process.

From the above macroeconomic analysis the most important aspects that might
affect the valuation process of emerging markets are

1. Considerable increase in financial depth should increase market liquidity,

efficiency, market microstructure in these countries
2. The high inflationary environment is still a common situation in emerging
markets; proper analytical framework must be developed to incorporate the
inflation in emerging countries.
3. Given the current investments in growth in most of the emerging markets
the upward pressure on interest rates should increase the cost of capital. In
situations like this many firms may raise capital through alternate sources
(e.g. Through sovereign wealth funds, etc.) . If this is the case what should
be the appropriate cost of capital in emerging markets.
4. Exchange rate volatility and currency devaluation are very important aspects
of emerging countries. To address this issue is highly important in the
valuation process.

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5.5 Probit Analysis for Emerging Countries:

Probit Analysis is a special type of regression model that is used to analyze the
binomially distributed response variable. In very simple words it the influence of a
variable on the probability of an even occurring. Like a normal regression model in
probit model the relationship between the response variable to the independent
variable is given by

Y= α+β X+ e

Where α = the y – intercept

Β = Slope of the line
e = error in the equation

Here the response variable in a binomial response variable so it has only two

In my model of probit analysis I want to test the probability of a country being

classified as an emerging market based on three parameters
1. The GDP/Capita
2. The market capitalization of the country
3. The ratio of market capitalization to that of the GDP of a country

Theses choice of parameters has been made after studying the methodology
employed by MSCI and S&P to classify countries as emerging, frontier and
developed nations. I wanted to test how influential these parameters are in
determining the classification

For the experimental setup, I collected the data for the three mentioned
parameters of 64 frontiers and emerging markets. All countries that are classified
as emerging by MSCI are assigned a binary value of 1 and the rest were assigned a
value of 0.

The equation of the above probit model can be stated as

Analysis of results: After running the probit analysis using stastical tool I got the
following results

Source Value Standard Wald

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error Chi-
GDP/Capita 0.029 0.194 0.022
Market Cap 1.100 0.513 4.592
Cap/GDP 0.353 0.229 2.378

In the above equation the coefficients indicate the maximum likelihood estimates
of the parameters under consideration.

Value / Standardized coefficients

(95% conf. interval)
Standardized coefficients

Market Cap

0.5 Market Cap/GDP



Figure 15: The Standardized Coefficients of the Probit Model

The graph shows the influence of each variable to classify a country under the
emerging markets. From the above analysis it seems that Market Cap has a major
influence on the classification of emerging markets. After this I plotted the
probability of each country as being classified as an emerging market.

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Probability of a country being EM

China 1.000
South Africa 0.972
India 0.928
Brazil 0.911
Korea, Rep. of 0.848
Russian Federation 0.789
Singapore 0.777
Malaysia 0.611
Chile 0.567
Saudi Arabia 0.517
Jordan 0.478
St. Kitts and Nevis 0.403
Mexico 0.377
Montenegro 0.358
Turkey 0.301
Colombia 0.301
Morocco 0.288
Thailand 0.288
Indonesia 0.258
Peru 0.257
Kazakhstan 0.248
Egypt, Arab Rep. 0.247
Philippines 0.247
Poland 0.241
Trinidad and Tobago 0.233
Mauritius 0.226
Croatia 0.211
Czech Republic 0.199
Jamaica 0.196
Nepal 0.194
Lebanon 0.192
Ireland 0.188
Kenya 0.180
Botswana 0.179
Panama 0.178
Slovenia 0.178
Iran, Islamic Rep. of 0.173
Hungary 0.171
Serbia 0.168
Argentina 0.163
Romania 0.161
Cote d'Ivoire 0.161
Vietnam 0.160
Pakistan 0.159

0.000 0.200 0.400 0.600 0.800 1.000

Figure 16: The impact of economic variables in classifying a country as an emerging Market

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The above plot shows that the selection of variable doesn‟t have that much of
explanatory power in classifying emerging markets. We can see a series of
countries that are not classified as emerging markets e.g. Jordan, Montenegro
ahead of many emerging countries. There are two possibilities here. First there are
other important variables that influence the decision of classifying a country as
emerging market. Second, the investors sentiments plays an very important role in
the choice of investable market capitalization. Slowly many of the frontier markets
are entering the emerging market category and through probit analysis we can
classify them into emerging markets for choosing the correct valuation framework.

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6. Importance of valuation in emerging markets:

This part of the thesis explores the importance of valuation in emerging markets.
As stated earlier, the last twenty years have seen a drastic change in the dynamics
of the economic geography of the world. When viewed through the lens of
international investment one can digress the influence of countries, trade zones,
multinationals and transnational companies in shaping todays globalized world.

Economic Integration has been one of the cornerstones of today‟s globalized world
and this has been achieved through global trade agreements, preferential trade
agreements, and the influence of world institutions like the WTO‟s in taking
concrete steps to promote free trade and liberisation of cross border investments.
According to UNCTAD, the number of bilateral investment agreements (BITS) in
the world has increased from 385 in 1989 to 2676 by the end of 2008 and the
number of double taxation treaties (DDT‟s) have increased reached over 2000.
Popularly referred to as the "Spaghetti bowl" of IIAs shows that almost every
country has signed a IIA in the world 10.

Figure 17: The "Spaghetti bowl" of IIAs

(Source : Wikipedia: IIA’s)

Multinational Companies have also played a very crucial role in the globalization
process in the past twenty years. The number of MNC‟s operating in the world
today has increased from 7000 in 1960 to around 80,000 in 2009. According to
one report the level of output in terms of trade, employment by Multinational
Companies have increased at rate higher than that of the growth rate of global
trade (McCann and Mudambi, 2005). MNC‟s account for almost 10 percent of the
world GDP, one third of global exports and 13% of the world fixed capital

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investment. The labor force employed by todays multinational stands at 73 million,
which has tripled since 1990.

The major vehicle of growth for most of the MNC‟s has been foreign direct
investment and it is the largest component worldwide stock of foreign investment.
International Monetary Fund defines FDI as follows:

“Direct investment is a category of cross-border investment made by a resident in

one economy (the direct investor) with the objective of establishing a lasting interest
in an enterprise (the direct investment enterprise) that is resident in an economy
other than that of the direct investor. The motiva tion of the direct investor is a
stra tegic long-term relationship with the direct investment enterprise to ensure a
significant degree of influence by the direct investor in the management of the direct
investment enterprise. The “lasting interest” is evidenced when the direct investor
owns at least 10% of the voting power of the direct investment enterprise. Direct
investment may also allow the direct investor to gain access to the economy of the
direct investment enterprise which it might otherwise be unable to do. The objectives
of direct investment are different from those of portfolio investment whereby
investors do not generally expect to influence the management of the enterprise”

The huge increase in FDI investments across the world shows an increasing
openness and connectivity of countries across the world. I studied the Foreign
Direct Investments time series that is available with IMF. There are some
interesting trends which are worth taking note of. The volume of FDI investments
has increased 20% annually over the past 20 years, but there is high variability of
YOY change in investments. The graph also shows that foreign direct investment is
a cyclical e vent which depends on the business condition of the global economy,
the effect of recessions and financial contagion around the world. There is a sharp
decline in investments during the 97 Asian crises, the Dotcom bubble, and again
in 2007 during the global financial meltdown.

Till now the volume of FDI investment in developed markets is much higher in
comparison to emerging markets but slowly there is a notable shift in the process
in the past 20 years. According to UNCATD report for each dollar invested, more
jobs was created in emerging economies than in developed markets. Global asset
value of MNC‟s in FDI‟s have increased more than their global employment level.
This shift in FDI flows is more towards capital intensive and knowledge intensive
activities concentrated in emerging markets.

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Total FDI investments in Developed Nations &

EMG Markets

YOY % Change in FDI Investment in EM's

FDI in Bn($)

800 30.00
600 20.00
400 10.00
200 0.00
0 -10.00
90 91 92 93 94 95 96 97 98 99 0 1 2 3 4 5 6 7 8

Years (1990-2008)

Total FDI in Emerging Nat Total FDI in Dev Nations YOY % Change in EMG

Figure 18: Comparision FDI by volume and growth in developed and emerging nations in the last two

(Source : Created by self from World Bank Database)

According to UNCATD, studies show that while making an international FDI

investment, decision-makers tend to base their judgment on parameters such as
lower labour costs, greater scope of communication along with accessibility and
transportation cost. Due to the structural changes in many of the emerging
countries, there is huge improvement in inter-connectedness and absorption of
low-cost knowledge related investments. The above graph shows the FDI
investments in top 6 emerging markets. On an average there has been a steady
growth of FDI investment of around 25% in these countries with china
experiencing a spectacular growth in FDI‟s among all the others. A rece nt survey
conducted by UNCATD reveals that according to top executives of multinational
companies, in the coming years China is going to be the top destination for FDI‟s
followed by India, Russi and Brazil.

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FDI Investments in Major Emerging Economies

FDI (in Bn$)

90 91 92 93 94 95 96 97 98 99 0 1 2 3 4 5 6 7 8

Years (1990-2008)
Brazil China India Mexico Russian Federation South Africa

Figure 16: FDI in emerging nations in the last two decades

(Source : Created by self from World Bank Database)

Although the FDI investments in emerging markets are catching up with that of
the developed world, there is a difference between the forms of FDI flows in the two
markets. Analysis of time series data by UNCATD re veal that de veloped markets
tend to receive investments in the form of M&A‟s while, in emerging markets the
type of investments are „Greenfield Investments’ . The number of such greenfield
FDI projects increased globally by 13% to some 11 800 projects in 2005.
Manufacturing accounted for 54% of these projects, with the service sector
accounting for 42% and primary industries accounting for 4%. In terms of broad
regions, South, East and South East Asia accounted for 3 515, or some 30% of
these greenfield projects.

6.1 Green Field Projects

Green Field investments are those projects, where multinationals invests and
builds a company from scratch. Greenfield projects are generally undertaken by
companies when they don‟t have the option of entering a market through a merger
due to lack of a specific type of industry, want to safeguard patents and
intellectual property rights, etc. So Greenfield projects tend to be risky and the two
main issues may arise during the valuation of a Greenfield enterprise.
1. Political and regime change risks
2. Operational Risk

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6.2 Mergers and Acquisitions in Emerging Markets:

M&A is a very versatile investment vehicle for international companies. Cross
border mergers are generally carried out with the following motive

1. To achieve geographic and industrial diversification

2. To accelerate growth
3. Industry Consolidation
4. Utilization of lower raw material and labor cost
5. Leveraging intangible assets

Total M&A in Emerging Markets

Transaction Value (in Mn $)


Total M&A in Emerging Markets

Figure 19: Volume of M&A in emerging nations in the last two decades

(Source : Created by self from World Bank Database)

The M&A activity in emerging markets has grown annually at 20 percent for the
past 20 years. Due to increased volumes of cross border mergers there are number
of issues that in valuations that companies faces. The graph also confirms the fact
that cross border mergers also occur in waves. It can also be observed that the two
peaks in the graphs were in 2000 and 2008 when P/E ratios of stock markets had
reached record levels. Whether it be multiple based valuation or discounted cash
flow valuation in cross-border transactions, there are lots of issues that the
involved parties face. I would like to list the main problems with cross-border
valuations, in the context of emerging markets that we will try to look into more
details in the later part of the thesis.

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1. The first issue that arises is the choice of currency to conduct the valuation
process, whether the valuation is carried out in local currency or home
currency. Many of the new emerging markets have volatile currency so how
do we address this issue.
2. The selection and application of multiples in emerging markets: To carry out
multiple valuations, selection of “comparable companies” or recently
completed takeovers is very important, but one might run into a problem in
the emerging markets where the universe of publicly traded companies is
pretty much limited. Different accounting standards, the proper projection of
business cycles and recessions in earnings or cash flow based multiples.
3. When it comes to discounted cashflow valuation: As emerging market
industries operate in a highly volatile political and economic environment so
acquisition of a target in emerging market is many times a strategic option
for the buyer, but in DCF valuation this flexibility is not present for the
buyer. How can real option be used if at-all in emerging markets along with
4. Incorporating Emerging Market Risks in Valuation: There are lots of risk
associated with emerging markets like sovereign risk , where unstable
government can pose a threat to the investing company. Operational Risks,
like lack of infrastructure should be incorporated with probabilistic weighted
5. Non performing debts: Many of the emerging market companies have non-
performing loans, so proper framework for addressing these non-performing
assets must be developed.
6. Taxation Issues: Taxation issues are other important aspects that need to be
analyzed very carefully.

6.3 Private Equity Investments in Emerging Markets:

With the relaxation of the economic trades and a series of privatization in the
emerging markets in the early 90‟s, the emerging markets slowly saw the
development of private sector. There was a rising demand for investment capital
which the traditional institutions of finances (both local and international) could
not address due to the riskiness of the firms and businesses. Here was an area
where private equity offered a important support of the development of the
industries in many of the emerging economies. Due to improved macroeconomic
conditions, openness to foreign investors and lucrative growth prospects, there
was a huge investment in private equity in emerging markets. The graph below
shows the amount of private equity investments in a few developed emerging

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markets compared to that of USA and UK. According to EMPEA 11 , the PE
investments have grown at a rate of 30 percent from 2002 only to fall to 14 percent
during 2008 due to the financial crisis.

PE Investments as a % of GDP
Russia 0.14%

Brazil 0.15%

China 0.20%

India 0.60%

UK 1.20%

US 1.40%

Figure 20: PE Investments as a % of GDP in a few countries

(Source : Created by self from Empea Database)

According to IFC 12 , a subsidiary of World Bank group- the scope in emerging

markets is tremendous as the private equity model in emerging markets is growth
driven and value extraction is through operational efficiency instead of the
traditional leverage and multiple expansion strategies that are followed in
developed world. The advantages of this are twofold – One, makes the associated
risk more operational than cyclical (affected by recessions). It provides the
diversification benefits for international private equity firms who have leverage and
multiple expansion strategies in developed markets.

Empea study shows that, industries that private equity firms target in emerging
markets are mostly closely held private companies, or new technology startups
which are dependent on the success of a single product and may run the risk of
being caught in a speculative bubble. These companies have very little history of
earnings, . Incorporating the effects of patent approval, or testing cycle or phases
of development in the capital budgeting process is very important to the valuation

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6.4 Global Portfolio Investments:
The basic principle of an efficient portfolio is based on proper diversification. So,
adding assets to the portfolio that are not perfectly correlated will enhance the
portfolio by increase in the return to volatility ratio. Research Studies by [] in the
late 90‟s show low correlation between emerging markets and the high potential for
growth in market capitalization of these countries. Past studies have shown
emerging markets to be comparatively small, less liquid and inefficient and are not
strongly correlated with developed markets.

Again any international investor who is investing in emerging markets will be

seeking reward for the two broad category of risk involved - the local risk and
foreign exchange risk. Macro-economic analysis has shown how volatile the
fluctuations are in currency markets. But with emerging markets the changes are
quiet rapid. Proper asset valuation is very important. The shortcomings in the
area of market information, market integration, and political risk are common
factors that skew the asset pricing process in emerging markets.

Hence, we see that for the valuation process that is used in different scenarios
whether it be Greenfield Investments, mergers and acquisitions or private equity
there are a few common points that are relevant to all the above investments. To
summarize the common valuation issues affecting different forms of investments:

1. Incorporation of country risk and operational risk in valuation process

2. Address the issue of insufficient market data for new or closely held
3. Accounting and taxation issues which are divergent with world standards
4. Efficiency and effectiveness of Capital Markets
5. Exchange rate and inflation problems

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7 The process of valuation:

The basic premise of valuation is based on the ability of the company to add
economic value to its holder. The concept of stock works on the expectation by its
holder to give him the expected future return for the investment that has made in
a particular holding. As the expected returns are in future, so there is an intrinsic
risk associated with the investment. The investor is ready to bear this risk
associated with a particular investment when he is given some incentive to do so.
This “incentive” when adjusted for the perceived risk gives the perceived value to
its stakeholder.

In simple terms the value of a company is linked directly to its level of earnings,
the dividends it pays, the risk associated with its operations, the growth rate and
the cost associated with raising money. The valuation of a company can be
classified in two broad categories –

1. The extrinsic value of a company: The extrinsic value of a company or asset is

the fair market value, i.e the value assigned by the market which is directly related
to the supply and demand mechanics of the asset. The extrinsic value is the
cumulative perception of the market participants. In extrinsic valuation, value of
companies, business units are referred which are similar in nature. Here in out
thesis we focus on techniques of relative valuation and how it can be applied to
emerging market economics.

2. The intrinsic valuation of a company: The value of an asset is a function of its

value driver‟s i.e. the value created from the operations . The intrinsic value is
determined using net cashflow generated through growth in revenue and the
return on invested capital. To determine the intrinsic value of a company the
inputs are modeled according to the environment of operation. Goetzmann (pg-444,
2006), defines a valuation model as a mechanism that converts a set of forecasts of
a series of company and economic variables into a forecast of market value for the
company‟s stock. The valuation model acts a decision making tool and when used
with precision can help in efficient decision making.

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Figure 21: A general valuation model

(Source : Own )

7.1 Relative Valuation in Emerging Countries:

Relative Valuation is defined as a valuation methodology where companies that are
to be valued are benchmarked against existing companies with similar profile of
products, market features, operating costs, financial structure and performance.
Companies in the same industries or serving the same customer segments are
compared so that there is consistency regarding the macroeconomic variables,
business cycles affecting the compared companies.

Relative Valuation Method or the market multiple method uses the market value to
determine the value of an asset. Typically market multiple is expressed as the ratio
of market price variable to that of a company value driver. Huge number of market
multiples can be established for companies which can be used to valuation but
these market multiples can be misused if not properly understood or
applied(Damodaran, The diagram below show (Andreas Schreiner,
2007, pg- 39) the classification of market multiples which follows a two
dimensional categorization of multiples. It divides market multiples based on two
broad factors 1.Type of market information that is required to be incorporated in
the numerator – equity value or enterprise value 2. The type of value drivers that is
reflected in the denominator

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Classification Based on Value Drivers of a Company

Accrual Flow Book Value Cash Flow Alternative Forward Looking
Multiples Multiples Multiples Multiples Multiples


Multiples P/EBIT P/(E+R&D) P/EBITDA2
Enterprise EV/SA EV/TA EV/OCF EV / (EBIT+R&D) EV/SA 1

P = (stock) price / market capitalization, EV = enterprise value, SA = sales / revenues, 01

= gross income, EBITDA = earnings before interest, taxes, depreciation, and amortization, EBIT =
earnings before interest and taxes, EBT = earnings before taxes / pre-tax income, E = earnings / net
income available to common shareholders, TA = total assets, IC = invested capital, B = book value
of common equity, OCF = operating cash flow, D = (ordinary cash) dividend, R&D = research &
development expenditures, AlA = amortization of intangible assets, KC = knowledge costs = R&D
+ AlA, and PEO = price to earnings to earnings growth ratio. Forward- looking multiples are based
on mean consensus analysts' forecasts for the next two years (I = one year, 2 = two years)

Table 6: Classification of Multiples based on Value Drivers of a Company

Adopted from: Andreas Schreiner, 2007

Relative Valuation is very simple to apply, thus its popularity. It is a very good
reflection on how the market values an asset. Relative valuation is different from
that of discounted cashflow valuation as it is totally based on investor sentiments
and rides the waves of market. When it comes to applying relative valuation in
emerging markets, then there are some serious hurdles that needs to be addressed

1. Relative valuation works best when there is liquidity and efficiency in the
market i.e. there are lots of people engaged in buying and selling. This keeps
the relative value close to its intrinsic value. In large markets like USA, UK,
and other developed countries this is not an issue. But in emerging

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countries where markets are inefficient and illiquid the relative value may
deviate contrastingly form that of the intrinsic value of an asset.
2. As the emerging countries are in a transition phase and the number of
industries listed in the stock exchange are not as vast as that of developed
countries. So the universe of comparable companies is pretty much
restricted. All sectors are not covered in emerging market companies. One
might argue that it shouldn‟t pose a problem as a company from which is in
the same industry can be compared with a de veloped market universe. But
we shouldn‟t that the macroeconomic environment of emerging countries
is very much different from that of developed markets
3. Contagion effects, Quantitative Easing, Carry Trades: It has bee n observed
that stock prices in emerging markets are highly synchronous (Chan,2005)
i.e. they move together. Many reasons has been cited for this but the most
prominent ones are related to the flow of capitals from emerging markets
Contagion effects like the Asian Crisis brought out the dark reality of
pumped up asset values in emerging markets. For the past one decade
interest rates have been very low in developed countries and with recent
steps taken up by US government like quantitative easing is bound to push
asset prices higher and threats the possibility of a bubble. To control the
effect of a growing bubble many emerging countries resort to the use of
capital controls which again makes market inefficient.

My main aim in this part of the paper is to explore how multiples from developed
countries can be adjusted so that it can be used in sync with that of emerging
countries. I looked at the stock prices of different companies but within the same
industry from the USA and other developed countries and compared it to that of
emerging countries. Intuitively, it is quiet appealing to believe that in a globalized
world, an industry or sector should have the same growth expectation and
somewhat similar asset prices but contrastingly this is not the case. There is not
much research in this field which states why stock prices vary so widely in the
same sector of developed and emerging markets.

Damodaran (2002) suggests that the main reason for difference is due to the fact
that emerging markets are considered riskier (in terms of macroeconomic and
political environment). Similar research conducted by Black, Love, Rachinsky,
(2006) in a few emerging markets concludes that corporate governance is the main
reason for the difference. Both the above stated reason are valid (although investor
perception have changed in the past 2/3 years 13 when many emerging markets
performed well during the recessionary environment when compared to developed

13 _us/news_room/pdf/2010/ma-survey-en-9feb10.pdf
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nations) The above two reasons are pretty much in line with that of the general
perception of high systematic and firm specific risk associated with emerging
countries and its impact on emerging market asset prices. To tackle the issues of
restricted universe of comparable companies in emerging markets many
practitioners use developed market companies as reference for emerging market
valuation. So i explored the existence of any possible framework and best practises
that can address this issue.

Pererio(2002,) suggests a frame work for converting multiples from for developed
market to emerging market . The diagram below shows the necessary adjustments
that needs to be made to get a emerging country multiple.

Adjustments that needs to be

of Companies 1. Accounting
and 2. Cross Border Country Risk
Transaction Correction Coefficient Adjusted
of Emerging 3. Intertemporal
Markets adjustments
4. Unsystematic Risk


Accounting Adjustments: Accounting Standards across countries vary a lot.

Accounting disclosure are not upto international standards which creates a
problem for translating multiples across countries. Pererio(2002) suggests that in
emerging countries there is no definitive classification between accoun ting reports
and tax statements, so in many countries the accounting report is submitted as
the tax report. This kind of practise tends to act like incentives for managers in
firms to depress accounting earnings to get tax benefits. In situations like this it is
very difficult to apply standard multiples to emerging countries. According to
Damodaran(2002) the best way to address issues like this is to use cashflow based
multiples. The logic behind the argument is that cashflows are less affected
compared to other earnings based multiples due to difference in accounting
practises. Concept such as price to free cash flow and its reciprocals also know as
Cash Flow Yield can be used in emerging market countries. But the hurdle is that
cashflows are volatile items compared to earnings, so the assumption that

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cashflow will be constant or consatantly growing is challenged in an emerging
market scenario.

Correction Coefficients: The method suggested by Pererio(2002) to calculate the

cross border adjustment coefficients is to take the annual emerging country PE
ratio and divide it by the US PE ratio to get the coefficient of adjustments . This
method is based on the assumption that there is a liner price relationship exists in
the stock market. This linear relationship is too big an assumption for an emerging
market scenario as market volatility, liquidity, price synchronicity is very common
issues in emerging markets. From the literature review and macroeconomic
analysis that I conducted, I hypothesize that cross sectional multiple regression
analysis can provide better estimates of an country PE ratio which then can be
used along with the US PE ratio to get the correct correction coefficient. The
procedure to develop the correction co-efficient is as follows

1. To identify the most influential macroeconomic variables that affect the PE

ratio of a country
2. Carrying out a cross-sectional regression to get the relationship between PE
ratio and macroeconomic variables
3. Test the data for linearity and multi-colinearity
4. Make the necessary changes like log linear transformation or exponential
transformation if found nonlinear.
5. Calculate the PE ratio based on the current macroeconomic environment
6. Divide it by the Developed Market PE ratio to get the correction coefficient

To execute the first step I thoroughly studied the seminal paper by Roll, Ross
(1984), on Arbitrage Pricing Theory where they identify four macroeconomic
variables that has major impact on the returns on an asset. These macroeconomic
variables are 1.Inflation 2.Industrial Production 3. Term structure of interest rates
4.Country Risk. To conduct the cross sectional regression analysis I collected the
data of emerging countries for the past 5 years. The data used for analysis was
extracted from Compustat and Bloomberg databases,

Countries PE Ra tios Interes t Ra tes % GDP Growth % Country Risk

Bra zil 14.61 15.17 3.57 48.5
Chi na 24.8 1.00 11.00 47.875
Col ombia 20.93 7.70 4.63 54.625
Czech Republic 9.35 3.83 3.65 30
Egypt 6.34 2.90 1.74 43.875
Hunga ry 29.58 5.25 8.26 29
India 14.96 5.98 5.41 51.75
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Indonesia 10.07 3.06 4.69 58.625
Mala ysia 20.42 2.49 1.69 35.125
Mexi co 17.22 0.22 4.78 42.5
Philippines 17.21 4.27 4.65 51.625
Poland 22.05 4.56 4.91 31.375
Russia 17.49 -2.23 6.29 57.875
S. Afri ca 18.95 5.17 3.68 44.15
Thailand 17.21 2.92 4.05 51
Table 7: Table showing the 5 years average of Major Macroeconomic Variables of Emerging Countries

The above data table shows the list of 15 emerging countries with PE Ratios,
Interest rates, GDP Growth % and Country Risk. The data for PE ratios is the 5
years normalized data collected from Compustat database. The Real interest rates
and GDP growth are normalized data series collected form World Bank database.
The country risk score is the one published by The Economist 14 and a 5 years
average of the data is taken.

Regression Setup: I assumed that that the PE ratio of a country is influenced by

the three major macroeconomic variable Interest Rates, GDP percentage and the
broad influence of country risk. The cross sectional regression can be stated by the


Results of the regression:

Regression Statistics
Mul tiple R 0.96
R Squa re 0.92
Adjus ted R Square 0.83
Sta nda rd Error 5.74
Observa tions 15.00

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Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 0.00 #N/A #N/A #N/A #N/A #N/A
Interes t Ra tes % 0.44 0.38 1.15 0.27 -0.39 1.28
GDP Growth % 2.29 0.62 3.69 0.00 0.94 3.64
Country Risk -0.09 0.08 1.03 0.32 -0.09 0.26

Interpretation of results: The regression equation now can be expressed in the


The above equation can be used to get an estimate of the country PE ratio by
plugging in the present macroeconomic data. The R-Square of the regression is
around 92%, which suggest good explanatory power of the macroeconomic
variables as an important contributor towards a countries overall PE Ratio.
Interest rates and country risk seem to have marginal effect on the overall PE ratio
of the country. The P-Value of GDP growth is less than 0.05, which indicates it is
statistically significant at a 5% level.

Tests for linearity and multicollinearity of the above equation:

1. Check for linearity: To check the linearity of the above equation, an analysis
of the residual plot is important. Econometric theory states that the residual
plots of multiple regression which are more concentrated around the mean
exhibits a linear relationship

Country Risk Residual Plot GDP Growth % Residual Plot Interest Rates % Residual Plot

50 50 50


0 0 0
0 50 100 0.00 5.00 10.00 15.00 -10.00 0.00 10.00 20.00
-50 -50 -50
Country Risk GDP Growth % Interest Rates %
2. Check for multicollinearity: A high P-value in interest rate and Country Risk indicates some marginal
effect of collineratity but tests using risk optimization tool indicates that the
level of influence is not significant.

As the above macroeconomic variables are in line with the linearity and
multicollinarity tests, so converting them to a lognormal or an exponential
equation is not necessary.

The use of a cross sectional regression as compared to the direct conversion

method suggested by Periro(2002) is much more forward looking as it takes the

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macroeconomic conditions of emerging market into account to for predicting the
PE conversion ratio.

Intertemporal Adjustments: When PE ratios from developed countries are being

converted to emerging countries then the time adjustments regarding the
comparable transactions should also be included if necessary (Perireo,2002, Pg -
279) .Suppose a series of US comparables are available for the time period T-1 and
this needs to be used for an emerging market environment. Then the necessary
conversion with the intertemporal adjustments should be given by

PE Emerging at time T = PE Adjustment Coefficient US- Emerging X (PE US at time T / PE

US at time T -1)X PE US Comparable T -1

Unsystematic Risk Adjustments: Adjustments for unsystematic risk is another

important hurdle which one comes across in emerging market countries. Market
multiples reflect company information and many times companies have minority
positions in other companies and these information are reflected in the stock price
and enterprise value and hence the market multiples. The main problem arises in
cross border acquisitions when the target company may differ considerably from
its peers. After a lot of research i didn‟t find any relevant material for proper
adjustments. I would suggest that precedent transaction analysis in an
international setting can be the best solution to the problem.

7.2 DCF Valuation:

There are different models of intrinsic valuation that are present (Residual Income
Model, Discounted Cash Flow, Economic Value Added) but my area of focus in this
thesis is DCF Valuation. The discounted cash flow approach (DCF) has three main

1. Future cash surpluses

2. The tax rate
3. The cost of capital

The principle of DCF is based on the time value of money where the future cash
surpluses of a company are discounted with an appropriate discount rate. The
determination of the value of a company using DCF method can executed in four
distinct steps.

1. The estimation of cash flow for e very year for a given time horizon.
2. Determine the risk profile of the cash flows.
3. Calculate risk adjusted discount rate

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4. Discount the annual cashflows with the discount rate and sum the present
value of cashflows

The value of an asset by the in a particular time “t” is given by


7.2.1 Steps in a DCF Valuation Process:

Determination of value drivers and growth rate of the firm: The first step involves
identification of key drivers of financial performance and uses them to project
Future Cash Flows. In case of developed countries –well defined laws, solid
regulatory bodies, availability of company and industry based information makes
this particular part comparatively easy when compared to a emerging country.

The possible problems that may arise while determining the key performance
driver in emerging economies are

1. Opaque accounting systems or not so strong financial regulatory system

might pose a problem
2. Hidden taxes, bribes and regulatory issues, which can to a particular state
or country wide can create problem
3. Company‟s reputation, involvement in ongoing legal proceedings, etc.
4. Laws related to recovery of assets at terminal value
5. Treatment of subsidized financing
6. Foreign Exchange Risks.
7. Many of the business in emerging markets are privately held business, so
there is a huge problem is extracting the true financial value drivers of the

The cash flow component: The second step in the process is the determination of
the the Free Cash Flow to a firm.

The free cash flow (FCF) is the cash that a company has after it has paid out all
cash operating expense and associated taxes along with the funds required for
capital expenditure and working capital but prior to the payment of any interest
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Free Cash Flow Calculation:

Earnings before interest and taxes
(Less) Taxes at marginal Tax Rate

Earnings before interest after taxes

(Plus) Depreciation and Amortization
(Less) Capital Expenditure
(Less) Increase/decrease in Net Working Capital
Free Cash Flow to a Firm

There are major hurdles that arise regarding the treatment of Cash Flow in
emerging economy. According to Copeland, Koller, Murin (2002, pg 378), the
problem faced are

1. The future cash flows needs to be converted from foreign to home currency
for that exchange rate forecasts are needed
2. High inflation environment will cause discrepancy in treatment of inventory,
depreciation and taxes as the inflation gap between the nominal and real
cash flow will widen within very short interval of time
3. Accounting differences in different countries will also be a major issue.

Determination of Weighted Average Cost of Capital: The discount rate (r) that is
used in the Discounted Cash flow analysis is the weighted average cost of capital.
The WACC is the required return of the invested capital. The debt and equity part
have different risks associated with it and the treatment of tax is different for both,
so the weighted average is taken to calculate the rate of return


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7.3 Asset Pricing Models:
The determination of Cost of Equity is an important pivot in the process of
valuation. It is defined as the rate of return that an investor seeks for investing in
a particular asset. This is one area of economics that cannot be explained by hard
science as the concept of risk and return varies from investor to investor and
depends on many factors. There is considerable research that has been conducted
in the past 40 years on this topic to capture the very essence of expected return by
factoring in the risk associated. By far the Capital Asset Pricing Model has been
able to act as the approximate estimate to help quantify the risk and expected

The review of the CAPM and other models is an integral part of this thesis. Next
part of my work involves in analyzing the asset pricing models that are present
today, their strengths and weaknesses, the underlying assumptions, the inputs,
past performance of these models. Through the macroeconomic environment
analysis of emerging markets we saw how they are different from the developed
countries in many ways. I would try to analyze, how capable these models are to
be able to work in emerging market environment.

7.3.1 The Capital Asset Pricing Model:

Investment Science involves taking decision under uncertainty and the two most
important considerations that need to be undertaken are the risk involved and the
expected return from taking those risk. The basic intuition behind the whole
issues had been there for centuries, but real substantial work on addressing the
measurement of expected return started after Harry Markowitz Efficient Frontier
theory (1958) where he argues that macroeconomic conditions influences asset
prices and most assets prices are correlated (the change in price of one affects the
other) and for this reason all of the risk cannot be eliminated by the investor who
holds a diversified portfolio. In his research, Markowitz showed through
quantitative research how correlation between different assets affects the benefits
of diversification. The benefits of diversification can only be achieved when the
correlation between the assets is very low.

The method of measurement of risk and expected return (Perold, 2004) are
underlying principle of the CAPM and similar models. The measurement of risk is
nonlinear while that of expected return in a portfolio is that of the weighted
average of the expected return, while the reduction of risk of a portfolio is achieved
by reducing the standard deviation of the portfolio through diversification. The
basic model that captures this observation is known as the Capital Asset Pricing
Model. The assumptions of CAPM:

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1. There are no transaction cost of assets involved and investments are
infinitely divisible
2. All investors have access to the same information and investor cannot find
under or overvalued asset in the market.
3. All investors hold a portfolio of risky assets in proportion that duplicates the
market portfolio
4. There is no personal income tax
5. An individual can buy and sell without affecting the price of the stock i.e
which means that no single investor can affect the prices of the stock
6. Investors are expected to make decision solely on the expected value and the
standard deviation on the return on their portfolio.
7. Unlimited borrowing and lending at riskless rate.

By taking these assumptions into account the CAPM has been modeled and is
represented by the following equation


Although the CAPM is the most popular and widely used model, it has been
challenged and criticized for not being able to explain many anomalies. The major
issues cited are

1. Addressing of the unsystematic risk component: There are two risk

components present, the systematic risk and the unsystematic risk. The
systematic risk or the market risk affects all the companies as a whole while
and the unsystematic risk or the firm specific risk is the risk that is very
much borne by the firms operations. The product of the beta and market
risk premium is the systematic risk. According to the concept of CAMP the
investor is paid for bearing the systematic risk, while he can eliminate the
unsystematic risk through diversification. While using the CAPM to derive
the cost of equity how does one factor in the unsystematic risk in the
equation. It has been argued that the unsystematic risk can be diversified
away the stake holders in the company which will make the investment.
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Bekaert and Harvey (2002), explores the different factors that affect the application
of the CAPM to emerging markets. The main issues listed are

1. The size of the emerging markets: It has been argued that the emerging
stock markets are small in size in terms of number of listed companies,
low market capitalization, liquidity and number of participants.
2. Highly Concentrated Markets: Emerging markets tends to be highly
concentrated with only a few companies being responsible for the major
float in the stock exchange
3. Inefficient Markets: Emerging Markets are inefficient as information is not
readily incorporated and the source of information is unreliable and

Modified CAMP Model: Empirical studies that have shown a very low value of the
cost of equity in emerging markets when the CAPM is applied which is not
intuitively appealing as macroeconomic analysis show that they tend to be risky as
compared to developed countries. So the CAPM has been modified by stacking up
a premium on the present equation which address the emerging market risk.


The Country Risk Premium (CRx ) is generally calculated as the spread between the
long term bonds issued by a country X with that of the long term bond of the
United States. Along with the general problems associated with the CAPM this
modification assumes that all investments in a country are exposed to the same
level of risks which might not be the case.

Sabal(2004) has argued that country risk are not totally systematic, as empirical
research have shown that stock returns in emerging and developed countries are
not highly correlated. I would like to conduct further research regarding this
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hypothesis as my belief is that due to globalization (as seen from macroeconomic
analysis) the emerging markets have integrated with the world market and the
correlation should be considerably high as compared to pre vious research that has
been conducted in this field.

The other issues that is quiet prevalent in the use of extended CAPM country risk
model is the problem of double counting. Copleland, Koller, Murin(2002) reports
the industry wide practice of double counting by discounting the projected
cashflow for country risk and along with the adjustment of the discount rate
decrease the clarity of a investment decision process.

7.3.2 The International CAPM or the Global CAPM Model: The global capital asset
pricing model was proposed by Stulz(1995), in which he states that due to rapid
globalization, markets are integrated at a much faster rate and for that reason
local investors will share the same risk of investing in local markets as in an
international environment and the returns of multinational corporations that have
business in foreign countries are correlated in such a way that the domestic
market will fail to capture the all systematic risk (Chen,2005). The estimation of a
beta must be based on a global market (e.g MSCI World Index). The basic premise
for the GCAPM to work is the condition that the local markets are not segmented.
Harvey(2002) cites transaction costs, market inefficiency, taxation, political risk as
the main cause of market segmentation.

If there are two companies C a and Cb situated in country A and B respectively and
both the companies have the same industry profile, cashflow, and capital structure
then according to the GCAPM the expected return is given by


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Like all cost of equity models, this model is all build on a list of assumptions

1. The consumption basket remains same for all investors in the global arena,
all though due to globalization the rate of convergence of economic and
social activity is very rapid but through the macroeconomic analysis we saw
the varying rate of globalization in different countries.
2. Purchasing Power Parity must hold in any point of time which translates to
again, a very highly integrated world as any deviation from the PPP means
opportunity of arbitrage. If the deviation tends to be for a long time then it
means that either the country has trade restrictions, subsidies, or some type
of economic barrier and which is a necessary condition for segmentation.

The equation is the same for country B when both the markets are integrated with
the world market. Stulz(1995) argues that represents the residual risk
that is common to both the local and global capital market. The integration of all
emerging countries are not the same, some are highly segmented while others are
highly integrated with the global capital markets. The global CAPM fails to address
the issue of countries which are not integrated with the world capital markets,
thus making it difficult to calculate the discount rate using the present framework.

7.3.3 The Godfrey and Espinosa Model: Godfrey and Espinosa (2005) identify three
main areas of concern when investments are made in emerging markets.
According to them the major risks are

1. Business Risk : These are the risk that have a direct impact on the business
like tax, regulatory and legal uncertainties,
2. Currency Risk: Devaluation, Volatility, etc.
3. Country Risk : Macroeconomic environment and political issues are
classified under this category

To calculate the discount rate they provide a framework where all broad categories
of risks are integrated with the basic CAPM model. The equation is given by


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The adjusted beta is given by


Godfrey, Espinosa (2005) also argue that the adjusted beta and the credit spread
are interconnected because the volatility of the local stock market depends on
political situation so the above equation is plagued with the issue of double
counting. To negate the effect of double counting they multiply the adjusted beta
by a factor of 0.60, as previous research has show that 40% of market volatility
can be explained by the credit spread of a country. So the final equation stands as

After analyzing the derived discount rate by this procedure, I feel that it is very
narrow in its scope of application as the risk free rate the market premium are
based on one hard base currency (i.e. US Dollar). Second, given the dynamic
growth and constant evolution faced by emerging markets this estimation of
discount rate is backward looking as the factor or 0.6 might change with time and
cannot me associated with all emerging markets. It also doesn‟t address the project
specific risk that a company might face in an emerging market.

7.3.4 The Credit Model: The credit model as proposed by Harvey Viskanta was
proposed for emerging countries where stock markets are not well developed and
there are no data historical equity or debt returns. In the method the author
proposes to run a regression between country credit ratings(independent variable)
and historical equity returns(dependent variable).

CE = α+β log(CCR Local) +ε

Where CE = Cost of Equity

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α = Regression Constant

β = Regression Coefficient

CCR Local = Country Credit Rating

ε = Error

If there are no credit ratings for a country present then the country risk guide
ratings can be used as an proxy for calculation the cost of capital of the country.

Summarizing the main issues in the above models:

1. Local market segmentation and global integration are important factors that
contribute to the determination of cost of capital.
2. The efficiency of emerging markets
3. Country risk and credit spreads
4. The risk free rate in emerging markets
5. The market risk premium
6. The calculation of the local beta and global beta and what insights they

Segmentation Market Efficiency

Local Beta vs Asset Pricing Country Risk and

Global Beta Credit Spreads

Market Risk
Premium Risk Free Rate

Figure 22: Factors affecting the asset pricing model

(Source: Own)

After analyzing all the Cost of Capital Models that are present, I would like to say
there is no particular correct way to calculate the cost of capital that can address

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all the issues that one faces in emerging markets. In deciding on the use of a
particular model, I feel there are two main parameters under which these models
can be classified.

1. Market Segmentation
2. Information Environment

From here, I would like to look into the factors of market segmentation and
information Environment with respect to emerging markets and prepare a
scorecard based on which the right model can be chosen for the right country.

7.4 Capital Market Analysis of Emerging Countries:

Market Segmentation Analysis: One major hindrance that one faces to apply the
Capital Asset Pricing Model or models derived from CAPM in the emerging markets
is the issues of market segmentation. Majority of the research in this field (mostly
conducted in the late 90‟s) supports the fact that emerging markets are not
properly integrated with the world markets. According to previous research
conducted the main factors that influence the country level of segmentation to that
of the world market are

1. The correlation of returns between local markets and global markets

2. The exchange rate stability
3. Capital Controls

7.4.1 Correlation between local and global markets: The first major test of market
segmentation is to analyze how the local stock markets of the emerging economies
are related to the global and the international stock markets. I collected the daily
data for emerging market stock returns for the past 20 years of individual stock
markets and the MSCI World Index, MSCI Emerging Market Index

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MSCI EM vs MSCI World (1990-99)

World Returns

100 120 140 160 180 200 220 240 260 280 300

EM Returns

Figure 23: Correlation between emerging market returns and world returns (1990-99)

(Source : Analyzed through MSCI and EMDB data available through Compustat)

MSCI EM vs MSCI World (2000-10)

World Returns

150 200 250 300 350

EM Returns

Figure 24: Correlation between emerging market returns and world returns (2000-10)

(Source : Analyzed through MSCI and EMDB data available through Compustat)

I categorized the data based on a period study of 10 years ( one form 1990-1990
and the other form 2000-2010). After that I ran a pearson correlation test between
the MSCI World Market Index and the MSCI Emerging Market Index. To show the
effect of returns between the two periods I ran a dot plot against the returns for the
two different period take into consideration. The process of integration has been
clearly captured in the above plot. We can see that in the last decade how the
returns between the local index and the global index have aligned itself almost in a
straight line indicating a strong correlation between the two markets.

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1990-1999 Correlation Coefficients

WI 1.00
EM 0.32 1.00
EURO 0.99 0.24 1.00
S&P 0.99 0.24 0.99 1.00

2000-2010 Correlation Coefficients


WI 1.00
EM 0.72 1.00
EUR 0.97 0.83 1.00
S&P 0.94 0.48 0.85 1.00

Where WI = MSCI World Index, EM= MSCI Emerging Market Index, EUR = MSCi
Eurozone Countries, S&P 500

Table 8: Pearson's Correlation Coefficients between Major World Index

From the correlation analysis of the period 1990-1999 it shows what most
research had shown, that the correlation between emerging markets returns and
and the world index was just 0.32 which is very low so is it with Europe ( 0.24)
and same with S&P 500 ( 0.24). This weak correlation coefficient among the
different markets created much promise among equity investors as a potential
source of international diversification. But in the last decade due to globalization
things have changed rapidly. From the analysis performed on the last decade, I
found that the correlation has increased to a significant level. The correlation
between MSCI World Index and MSCI Emerging Market Index has jumped from
0.32 to 0.72 an increase of around 127% and that of emerging markets with that
of Europe to .83. The most interesting observation is the correlation between the
emerging markets with that of the S&P 500 the results were to my surprise was
pretty low given the influence of American investments around the World.

This high correlation encouraged me to carry out further correlation analysis

among the individual emerging markets with that of the world index. The two main
reasons for carrying out these tests are

1. To see how the emerging markets fair against each other and to that against
the world index so that we can get an idea if any diversification benefits exist

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if emerging markets are treated differently as through economic analysis we
saw that they vary to one another to a large extent.
2. To help us create a scorecard based frame work so that we can rank the
countries based on correlation coefficient which can be used to decide the
cost of capital applicable to a particular country.


5 A D N
0 O
WI 1.00
EM 0.72 1.00
BRICS 0.68 0.99 1.00
EUR 0.97 0.83 0.79 1.00
S &P 0.94 0.48 0.43 0.85 1.00
BOVES 0.53 0.95 0.97 0.65 0.26 1.00
MXX 0.55 0.96 0.96 0.68 0.28 0.98 1.00
IND 0.57 0.97 0.97 0.69 0.31 0.98 0.98 1.00
CHN 0.59 0.75 0.78 0.68 0.43 0.71 0.72 0.73 1.00
INDO 0.51 0.95 0.96 0.64 0.25 0.99 0.98 0.99 0.72 1.00
EGP 0.65 0.97 0.96 0.78 0.39 0.93 0.94 0.94 0.66 0.92 1.00
POL 0.78 0.94 0.91 0.88 0.55 0.85 0.90 0.88 0.73 0.85 0.91 1.00
HUN 0.72 0.93 0.89 0.82 0.49 0.85 0.89 0.88 0.59 0.85 0.92 0.96 1.00
TURK 0.60 0.95 0.93 0.71 0.35 0.94 0.95 0.96 0.64 0.95 0.92 0.91 0.94 1.00
SA 0.57 0.96 0.96 0.71 0.29 0.97 0.99 0.97 0.73 0.96 0.96 0.91 0.89 0.93 1.00
THAI 0.54 0.90 0.87 0.67 0.28 0.87 0.88 0.88 0.52 0.88 0.89 0.87 0.92 0.92 0.87 1.00
S INGA 0.85 0.95 0.93 0.91 0.67 0.86 0.88 0.89 0.78 0.87 0.88 0.94 0.90 0.89 0.88 0.81 1.00
COL 0.69 0.91 0.89 0.72 0.52 0.92 0.95 0.94 0.63 0.91 0.91 0.87 0.90 0.97 0.93 0.87 0.87 1.00
PHIL 0.70 0.96 0.95 0.80 0.47 0.93 0.95 0.96 0.78 0.94 0.91 0.94 0.92 0.95 0.94 0.86 0.96 0.92 1.00
MAL 0.64 0.94 0.93 0.74 0.41 0.93 0.94 0.94 0.77 0.94 0.88 0.90 0.87 0.92 0.91 0.86 0.92 0.88 0.96 1

Here WI = MSCI World Index, EM = MSCI Emerging Market Index, BRICS= MSCI BRICS Index, EUR = MSCI
Europe Index, SP500 = MSCI S&P 500 index, BRA= Brazil(BOVESPA), MXX= Mexico, IND= India, CHN= China,
INDO = Indonesia, EGP = Egypt, POL = Poland, HUN = Hungary, TURK = Turkey, SA= South Africa, THAI=
Thailand, SINGA= Singapore Index, COL = Colombia Index PHIL= Philippines Index, MAL = Malaysia Index.

Table 9: Pearson Correlation Coefficient between developed and emerging countries

From the above correlation chart we can see the average correlation between
countries. In general the emerging markets have very strong correlation among
themselves and over all the markets have moved from a segmented to a more

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integrated one in the last 10 years. This correlation also shows the decrease in
diversification benefits that international investors seek by investing in emerging
markets. I also think that partly explains the global contagion especially the Asian
Crisis and how many emerging countries were affected. The strong interconnection
between the markets may be due to similar macroeconomic environment, risk
perception on the part of international investors.

The other important point that comes to the forefront from this chart is the high
correlation among countries that are located in the same geographical region. e.g.
like Poland, Hungary have relatively high correlation coefficient as they come
under the European union so they bound by the same trade agreements and laws.
The same thing can be noticed with the Asian Tiger Economies, which comes
under the common trade region so they have quiet strong correlation.

7.4.2 Capital Access:

Another important parameter for measuring the integration emerging markets is
the access to capital to fund projects. To analyze this I studied the report
published by Milken Institute an independent economic research group15 . They
rank the countries based on seven components. The major components that I
thought influenced market segmentation are listed as follows

1. Macroeconomic Environment:
2. Institutional Environment
3. Financial and Banking Institution
4. International Funding

Choice of the following factors:

Macroeconomic Environment: The macroeconomic environment addresses issues

which are related to proper running of a business. Parameters like inflation,
interest rates, financial sophistication are used to prepare the score. (Liu, Lin,
1999) has suggested that these macroeconomic conditions in some way affect the
segmentation of a market.

Institutional Environment: Institutional Environment like mechanics of the judicial

system, levels of corruption, bankruptcy procedures, affect the way business
decisions are made, so they play a vital role in the integration of the country to the
world economy.

Financial and Banking Institution: Solid financial and banking institution results
in good integration with the world economy.

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International Funding: Parameters such as exchange rate volatility, international
reserve holdings, types of investments: portfolio, foreign direct investment, capital
inflows and outflows, and sovereign ratings also affect the countries integration to
the world economy.

Milken Institute Research Scores + WI Correlation Score +Financial Globalization

Countries ME IE FI IF FG WI Total Rank of
Score Score Score Score Score Score Score Countries
Singapore 9.5 8.88 7.8 7.33 9.75 9 52.26 1
Malaysia 8.67 7.41 6.7 5.75 7.79 8 44.32 2
South Korea 8 7.76 6.7 5.36 6.1 7 40.92 3
Hungary 7.33 6.06 5.9 5.58 9.04 8 41.91 4
Thailand 7.67 6.65 6.3 5.92 6.92 6 39.46 5
SouthAfrica 5.83 6.94 6.7 4.25 7.01 8 38.73 6
China 7 6.59 4.6 5.42 5.68 6 35.29 7
Mexico 7.33 5.81 4.6 4.5 6.31 6 34.55 8
Turkey 6.5 5.65 4 3.75 6.3 8 34.2 9
Egypt 6.33 5.24 4.4 5.25 5.63 6 32.85 11
India 5.83 4.76 5.1 5.5 4.47 6 31.66 16
Brazil 5.17 4.65 5 5.83 5.82 6 32.47 11
Russia 6.5 4.47 4.2 5.17 5.8 6 32.14 12
Poland 6.5 4.47 4.2 4.08 7.71 7 33.96 10
Colombia 5.17 4.76 5.1 4.17 5.74 7 31.94 15
Indonesia 5.33 4.65 4.6 4 6.51 6 31.09 16
Philippines 6 3.29 3.7 3.75 5.99 7 29.73 17

ME = Macroeconomic Environment, IE = Institutional Environment, FI = Financial and Banking

Institution, IF = International Funding, WI = C orrelation with World Index, FG = Financial
Globalization Scores.

Table 10: Score Card of Emerging Markets for evaluation market integration

The above scores provide a good overview of the emerging countries in terms of
integration with the world market. When compared with the developed nations
where the average score is 41 and above in the 5 parameters that I used to come
out with the ranking. On an overall basis the emerging markets are pretty much

To build the score table for correlation I assign a full 10 to countries with
correlation coefficient 0.9 and above similarly 9 to countries with coefficient 0.8 or
above and hence forth.

Market Information: Many of the asset pricing models are based on the
assumption that information is properly integrated in the market. Efficiency in
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market is a major factor which determines which pricing model to use. Variables
such as industry beta, risk premium cannot be trusted if markets are not efficient.
According to Harvey(1995) the major important factors that contribute to proper
integration of information in capital markets are

1. Market Liquidity
2. Concentration ratios in market indices
3. Market Efficiency
4. Opacity and Government rules and regulations
5. Synchronicity of stock markets

7.4.3 Market Liquidity: Prices are more accurately captured by liquid markets
compared to illiquid market as it allows the investor to move money at a much
quicker rate when opportunities arises compared to a illiquid market where the
asset prices are pretty much stagnant. The liquidity of the stock market depends
on the number of companies listed in the exchange then the turn-over velocity. To
get a comprehensive view on the stock market I analyzed the stock exchange data
of number of companies registered in the emerging market stock exchange.

Countries Total Domestic Foreign Total Market Market Cap/

companies companies Capitalization Company Ratio
Brazil 386 377 9 392 1337247.68 3411.35
Colombia 87 87 0 89 140519.92 1578.88
Mexico 406 125 281 373 352045.44 943.82
India 4955 4955 0 4921 1306520.25 265.50
Malaysia 959 952 7 976 286157.30 293.19
Indonesia 398 398 0 396 214941.47 542.78
South Korea 1788 1778 10 1793 834596.86 465.48
Philippines 248 246 2 246 86349.43 351.01
China 870 870 0 864 2704778.46 3130.53
Singapore 773 459 314 767 481246.70 627.44
Thailand 535 535 0 525 176956.07 337.06
Hungary 46 42 4 43 30036.63 698.53
Egypt 313 312 1 373 91207.34 244.52
Turkey 315 315 0 317 233996.66 738.16
South Africa 396 351 45 411 799023.75 1944.10
Russia 234 234 0 233 736306.71 3160.11
Poland 486 470 16 458 150961.53 329.61
Table 11: Market Liquidity of Emerging Markets

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From the above table we can see that India has the highest number of companies
listed in the stock exchange, while china has the highest market capitalization. On
an average there are around 600 companies in every country in the emerging
markets as compared to the standard average of around 1500 in the developed
nations. The market capitalization to number of company‟s ratio show that in
countries like India where there are many companies listed but the proportional
amount of market capitalization is very low. The most possible reason might be
due, high cost of debt so company prefer raise money through stocks.

Turnover Ratio
Liquidity Ratio

USA 35.40
China 26.34
Italy 16.21
South Korea 15.29
Turkey 13.51
Germany 12.46
Norway 11.00
Spain 10.09
Tokyo 9.36
Hungary 8.82
Australia 7.25
Thailand 6.89
England 6.04
Brazil 5.58
Hongkong 5.04
Egypt 4.55
Singapore 4.45
South Africa 3.81
Poland 3.55
Indonesia 3.09
Mexico 2.74
India 1.53
Phillipines 1.51
Colombia 1.17

Figure 25: Stock Market turnover ratio (2009)

(Source : Analyzed through data available through Compustat)

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The graph shows the turnover ratio of major stock exchanges around the world.
The turnover ratio of the total value traded to the total market capitalization in one
month. The data is the average turnover ratio for the year 2009. A high ratio
means that a large number of shares were traded in the market. From the above
graph we can see that major developed nations have a very high turnover ratio
while the emerging markets are clustered around the base at around 5 percent. A
high turnover ratio is associated with high amount of liquidity in the market and
also low transaction cost.

7.3.4 Concentration of Companies in Stock Exchange: The concentration ratio is an

important factor while analyzing market information. (Harvey,2005) has argued
that in emerging markets, the total market capitalization is dominated by a few
companies and the movement in prices of smaller companies are overshadowed by
this. To analyze the concentration ratio, I used the data available with World
Federation of Stock Exchanges16.

Countries Stock Market cap. of Turnover value of

Exchange top 10 companies Top 10 companies


USA NYSE Euronext (US) 15.68% 29.23%

Australia Australian SE 43.79% 42.36%
Spain BME Spanish Exchanges 38.12% 64.29%
Italy Borsa Italiana 61.94% 78.69%
Germany Deutsche Börse 48.19% 36.03%
London London SE 41.33% 17.83%
Japan Tokyo SE Group 17.58% 19.59%
Average 38.09% 41.15%

Brazil BM&FBOVESPA 54.76% 47.21%
Colombia Colombia SE 72.80% 77.54%
Mexico Mexican Exchange 63.11% 73.76%
Malaysia Bursa Malaysia 39.32% 32.00%
Indonesia Indonesia SE 48.36% 51.20%
South Korea Korea Exchange 33.65% 19.17%
Phillippines Philippine SE 48.70% 60.73%
China Shanghai SE 41.16% 12.91%
Singapore Singapore Exchange 33.02% 33.35%
Thailand Thailand SE 48.24% 46.49%
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Hungary Budapest SE 96.46% 98.83%
Egypt Egyptian Exchange 39.42% 32.56%
Turkey Istanbul SE 50.43% 44.28%
Russia MICEX 66.06% 93.05%
Poland Warsaw SE 56.73% 64.19%
South Africa Johannesburg SE 47.90% 50.93%
India Bombay SE 30.05% 29.32%
Average 51.19% 51.03%
The above table shows the contribution of the Top 10 companies in their respective stoc k
exchange. The average contribution in developed countries is around 38% while that in
emerging economies its around 51% percent. This shows a pretty high concentration of the top
market movers in the stock exchange.

Table 12: Table Showing the comparison of contribution of top 10 companies in the stock exchange

7.3.5. Transparency: Transparency is another important factor in the analysis of

emerging markets. It is a common understanding that due to complicated laws,
regulations, government interventions, the business environment of emerging
markets are not that open. To analyze this I studied the Opacity Report published
by Miliken Institute. This report is based on the flowing parameters: Corruption,
Legal System Inadequacies, economic enforcement policy, accounting standards,
corporate governance and regulation. This report act as a very good benchmark for
analyzing the information environment form transparency point of view.

Countries Brazil Mexico India China Indonesia Egypt Poland Hungary

Score 5.7 6.3 5.9 5.8 6 6.6 6.8 7
Countries Turkey South Af Thailand Singapore Colombia Philippines Malaysia Russia
Score 6.4 7.6 6.3 8.6 5.6 5.5 6.8 6
Table 13: The transparency index score of emerging countries

7.3.6. Market Efficiency: A market is said to be efficient when the price of an asset
reflect all the information associated with it. The processing and quality of the
information is of prime importance. In efficient market theory there are three form
of efficiency. According to my findings prior market efficiency research has been
conducted for different emerging markets. The table below shows the emerging
countries where efficiency tests have been conducted and the observed results.
After going through individual research paper, I felt that many of these tests are
not concrete, but they do provide some guidance for signs of weak form of market

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Market Efficiency Studies
Countries Conducted Study Form Research
Efficiency Observation
Brazil H M P Capobianco, A M Cister & B F Maceio(2002) 
China H. R. Seddighi; W. Nian(2004)  Seasonal Causality
Cecilia Maya Ochoa,Gabriel Ignacio Torres Avendao
Colo mb ia (2005) × Micro Efficient
Czech Republic I Bechev(2003) × Very Weak Form
Egypt, Arab Rep. M Mecagni, MS Sourial(1999) ×
Hungary I Bechev(2003)
India S Poshakwale(2006) × Day of the week effect
Indonesia RW Click, M G Plu mmer(2005)
Malaysia D Karemera, K Ojah, JA Cole(1994) 
Mexico No conclusive research
Philippines No test
Poland I Bechev(2003) ×
Federation HALL, Stephen and Giovanni URGA(2002)
South Africa K Jefferis, G Smith(2004) 
Thailand No conclusive research
Contradictory Results
Turkey C Buguk, B Wade Bro rsen(2003) × Observed
Devel oped
Australia 
Italy 
Canada 
France 
Germany 
Spain 
United Kingdom 
United States  Partial Semi Strong Form
Table 14: Market Efficiency Studies in Emerging Markets

7.3.7. Stock Market Synchronicity: Very recent studies (Morck,2000) has found
that in emerging markets there is a very equity market price synchronicity. The
main outcome of this study was that countries with low GDP/capita had very high
synchronous movement in stock prices and this phenomenon couldn‟t be
explained either by market size or the macroeconomic environment of the country.

The market synchronicity is able to capture the market structure, investors

trading behavior. Further research in this area (Lin, Myers, 2005) attributes this
high synchronicity phenomenon to higher macroeconomic risk or lack of
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diversification across industries in emerging economies. They further argue that
lack of information and transparency affects the division of risk between insiders
and outsiders of a firm which increases the stock price synchronicity.

Due to the mathematical denseness and lack of available data, I couldn‟t carry out
the synchronicity test on my own. So I used the research data (Khandaker, Heaney,
2009) of synchronicity of prices in emerging markets to create the scorecard.

Countries Price
Singapore 0.69
Malaysia 0.73
South Korea 0.6
Hungary 0.65
Thailand 0.66
South Africa 0.6
China 0.73
Mexico 0.66
Turkey 0.75
Egypt 0.65
India 0.65
Brazil 0.64
Russia 0.7
Poland 0.66
Colombia 0.66
Indonesia 0.68
Philippines 0.65

Table 15: Stock Price Synchronicity

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7.3.8 Financial Information Score Card
Market Information Score Card
Countries Market No of Market Opacity Market Market Total Rank
Conc Score Comp. Score Efficiency Score Synchronicity Liquidity Score
India 8 8.5 6 5.9 3.5 1.3 33.20 1
South Korea 7.63 5.4 5 7 4 4.05 33.08 2
China 6.88 4.48 6 5.8 2.7 6.26 32.12 3
South Africa 6.21 4.03 6 7.6 4 3.81 31.65 4
Singapore 7.70 4.39 6 8.6 3.1 1.8 31.59 5
Hungary 1.35 3.66 6 7 3.5 8.82 30.33 6
Malaysia 7.07 4.6 6 6.8 2.7 3 30.17 7
Egypt 7.06 3.99 2 6.6 3.5 4.55 27.70 8
Brazil 5.52 4.01 6 5.7 3.6 2.11 26.94 9
Indonesia 6.16 4.02 5 6 3.2 1.6 25.98 10
Thailand 6.18 4.15 3 6.3 3.4 2.3 25.33 11
Turkey 5.96 3.9 2 6.4 2.5 3.7 24.46 12
Mexico 4.69 3.99 3 6.3 3.4 2.74 24.12 13
Poland 5.33 4.08 2 6.8 3.4 1.7 23.31 14
Russia 4.39 3.85 4 6 3 1.5 22.74 15
Philippines 6.13 3.87 1 5.5 3.5 1.3 21.30 16
Colombia 3.72 3.73 2 5.6 3.4 1.2 19.65 17

After assigned a score to the merging countries based on the following parameters:
Market Conc, Market Efficiency, Opacity of doing business, Market Synchronicity,
Market Liquidity. This score along with the Market Integration scores will act as a
guide to help us apply the cost of equity model to the respective countries

Countries Market Info Integration

Score Score
Singapore 31.59 52.26
Malaysia 30.17 44.32
South Korea 33.08 40.92
Hungary 30.33 41.91
Thailand 25.33 39.46
South Africa 31.65 38.73
China 32.12 35.29
Mexico 24.12 34.55
Turkey 24.46 34.20
Egypt 27.70 32.85
India 33.20 31.66
Brazil 26.94 32.47

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Russia 22.74 32.14
Poland 23.31 33.96
Colombia 19.65 31.94
Indonesia 25.98 31.09
Philippines 21.30 29.73



Zone 1 Zone 2

Market Integration Score

South Korea
South Africa

35.00 China
Colombia Russia
30.00 Phillippines
Zone 3 Zone 4


15.00 20.00 25.00 30.00 35.00
Avaibility of Market Information

Figure 22: Two by Two Matrix showing the relative state of emerging markets in terms of Market
Information and Integration
(Source : Own)

The above graph shows the plot of the scores of level of market integration and
availability of market information. I divide the dot plot in 4 distinct zones,

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Zone 1: It represents those countries which have very high marke t integration but
foreign capital market information is not that easily available. This is the zone
where the the Global CAPM can be applied directly to obtain the cost of capital.

Zone 2: This represents the zone where information is easily available and the
country is highly integrated. The local CAPM can be applied to these countries as
they almost behave like developed economies. Countries such as Singapore,
Malaysia, Hungary, South Korea, South Africa falls.

Zone 3: This represents those countries with low level of both capital market
integration and availability of market information. The Harvey (2005) credit model
and asset pricing models which are adjusted for political risk and country
segmentation are best suited for these countries. Philippines, Colombia, Russia,
Poland, Turkey currently fall in this category.

Zone 4: These are the countries with low level of world integration and high level of
availability of market information. Here multifactor models like the Goldman Model,
Godfrey Espinosa Model can be applied to these countries to calculate the cost of
capital. Countries like China, India, Brazil, Indonesia falls in this category.

Although the analysis is on relative basis i.e. in comparison to de veloped markets

and given the very dynamic nature of emerging markets the movement of these
countries into different zone can be very fast. But, the above framework does
provide us with an insight on how to use the cost of equity models that are

7.4. Risk-Free Rate: Whenever an investor or a company wants to make an

investment in an asset or project there is as expectation of return involved. In
finance, the difference (or variance) of the expected return and real return captures
the risk associated with the investment. In an investment where the variances
between the real return and expected return are zero, i.e. the probability of default
is zero then that investment is a risk free investment.

Damodaran(2000) cites two primary conditions for an asset to be risk free.

1. The asset must be risk free which means that there can be no default risk.
Securities issued by private companies are never risk free. It is generally
assumed that government securities are risk-free, for they have the power to
print money.
2. There must be no reinvestment risk: Reinvestment risk is defined as the risk
associated with the uncertainty of the future investment rates of a security

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e.g. 5 years Treasury bond is not risk-free as the coupons of the bonds will
be invested at rates that cannot be predicted today.

For investors in developed countries, it is not difficult to obtain a risk -free rate as
they have well developed bond markets which are very liquid and very stable
economic conditions. The yield of long term treasury bonds in USA can be used as
the riskfree rate. Complication arises when dealing with investments in emerging
market economies. Due to the long history of defaults in emerging markets the
government bonds issued in dollar denominated as well as local currency are not
totally riskfree.

Soverign Defualt in EM's Soverign Defaults by Region in past 100 years

Brazil 5
Mexicoa 4 South America
Colombia 4 5%
Chile 4 Europe
Turkey 4
Greece 3
50% Africa and Middle
Egypt 2
Russiaa 2
Poland 2 Asia
Morrocco 1 25%
Philippines 1
Indonesia 1
Hungary 1

Figure 26: Sovereign Defaults in the Emerging Countries

(Source: Sturzenegger(2007)

The above graph created from the data provided by Sturzenegger(2007) shows the
large number of defaults in emerging countries in the past one hundred years.
Although most of these defaults occurred in the early part of the century but none
the less many of the mentioned countries have defaulted in the recent past. Almost
50 percent of these defaults come from the Latin American Countries. This poses a
serious challenge for finding a risk free rate in emerging markets.

There are number of methods suggested by academics to deal with this issue. I
have researched each of these methods thoroughly looking into the strengths and
shortcomings of the given methods

Methods to calculate the risk-free rate:

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Copeland (2002) suggests using the US Bond Yield + Inflation Differential as the
risk free rate; here the inflation differential is the compounded difference between
local inflation rate and US inflation rate for the past 10 years.

Bond Yields of Different Countries(in %)

4.97 5.2

2.6 2.75 2.52 5 Years Yield

1.7 1.63 1.71 10 Years Yield

USA Japan UK Australia Germany

Figure 27: Bond Yields in different developed countries

(Source : Bloomberg)

The above graph shows the yield of government bonds of AAA rated countries who
have very less probability of default and the power to print money(except Germany).
Here we see that the yield of USA 10 yr bond is 2.6% and that of Japanese bond
denominated in Japanese yen is 0.8%. This difference arises due to the inflation
expectation in currency.

The choice of different riskfree rate of similar AAA rated sovereign bonds poses an
important question i.e. which one of the risk free rates to use. The choice is very
easy for an American investor but if the investor is from France who wants to
invest in Brazil then which riskfree rate must he use, the 10 years yield on French
bond or 10 years yield on German bond as both will be euro denominated issues.
Copeland (2002) suggests to carry out the cashflow analysis in the currency in
which the riskfree rate of treasury bond is used as reference.

I feel that this method makes a very strong case for itself, but it is not that simple
to implement due to the following reasons.

1. The long-term currency exchange risk that is involved in modeling of future

cash flows is neglected. We have seen from the macroeconomic analysis
most emerging markets have highly volatile currency and inflationary
environment so when one calculates the cash flows of Brazilian company in
Euros for a period of 10 years then the assumptions related to exchange
rates becomes very strong.
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2. Exchange rate derivatives are available for the maximum period of two years,
which raises uncertainty of exchange rate risks beyond that period and they
are available only for major currencies.

The second method suggested is to use the local bond yield and from that deduct
the sovereign risk and add the duration differential to the process. Here the
sovereign risk premium is the difference between the local government bond issued
in US dollars and the equivalent maturity of government US bon ds and the
duration differential is the change in yields between bonds of different maturities.

Local Currency bonds seems to be an obvious choice because emerging market

governments are not expected to default in their local currencies and there is
tremendous support of World Bank, Asian Development Bank to promote local
currency bonds. But as research has shown there are many issues related local
currency bonds

1. The local currency bond market in emerging markets is at a very nascent

stage whose development took place only after the Asian Crisis with the aim
to avoid over reliance on dollar denominated debts and to channel local
savings to fund government projects. The maturity of these bonds is very
short which poses a threat of reinvestment risk when the yields of these
bonds are used as a proxy for the risk free rate. After analyzing the time
series data provided by Bank of International Settlement(BIS) we see that in
many of the emerging countries the average maturity of the bonds has
increased dramatically. Most of the emerging markets now have a long term
debts denominated in local currency. So many of the concern regarding the
short term maturity of these debts are held redundant due to rapid
improvement in emerging markets.
2. Historically emerging countries has a high level of debt to GDP ratio (which
has hovered around the 80% mark on an average), but recent fiscal
discipline and the impact of globalization has helped many of the emerging
economies to tighten up the loose fiscal policy.

The third method suggested to derive the riskfree rate in emerging markets by
Damodaran (2006), is to use the sovereign bond yield of emerging countries and to
strip it off the sovereign risk that is embedded in the sovereign bond yield and to
add back the inflation differential to the sovereign yield.

The important point to note is the removal of the sovereign risk from the risk free
rate. The method suggested by Damodaran (2006), is to remove the sovereign risk
from the risk-free rate is to subtract the sovereign default spread from the local
government bond yield. Studies have shown that these spreads are highly
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influenced by the sovereign bond ratings assigned by the rating agencies. Keeping
in mind the recent criticism that Moody‟s and S&P‟s faced with their lack of failure
to anticipate the defaults in some peripheral euro economies, serious question has
been raised about the rating methodology and its implication.

Alternative method by Hull &White(2004), suggests using the credit default swap
spreads to address the issue of the sovereign risk. The credit default swap market
has increased by leaps and bounds in the last few years. CDS provides insurance
against default in a security. The spread between the buying and selling of CDS
acts as a very good proxy for the sovereign risk of a country. Event study
conducted in this area shows that CDS is a leading indicator of sovereign risk
compared to sovereign default spreads which are more influenced by rating
agencies and acts as a lagging indicator. For carrying out my research further, I
collected data from Bloomberg regarding the sovereign rating, default spreads and
the CDS spreads.

RiskFree Rates Method of Calculation

Method 1 Rf = US 10 Yrs Bond Yield + Inflation Differential
Method 2 Rf= Local Currency Bond Yield – CDS Spread
Method 3 Rf=Sovereign bond yield of EM Country + Inflation Differential – CDS Spread

US Countr Defaul Sovereig

10 Local y t n CDS Inflation Risk free Risk free Risk free
year Rating Sprea Sprea Differenti
s Currency s d Bonds d al Rate Rate Rate
Bon Method Method
d Bond 1 Method 2 3
Countries Yield Yield
Brazil 2.60 11.87 Baa3 1.59 5 1.27 4.3 6.92 10.6 8.05
China 2.60 3.70 A1 0.93 2.7 0.78 -0.7 1.88 2.9 1.19
Colombia 2.60 7.10 Ba1 2.55 3.82 1.23 3.7 6.30 5.9 6.29
Republic 2.60 3.66 A1 0.93 0.93 0.2 2.83 2.7
Egypt 2.60 13.00 Ba1 2.55 5 2.37 5.0 7.57 10.6 7.60
Hungary 2.60 7.03 Baa1 1.41 4.9 2.85 3.6 6.16 4.2 5.61
India 2.60 8.13 Baa3 1.59 4.1 1.27 3.0 5.56 6.9 5.79
Indonesia 2.60 7.51 Ba2 2.65 3.6 1.70 5.9 8.48 5.8 7.78
Malaysia 2.60 3.86 A3 0.98 0.88 -0.4 2.22 3.0
Mexico 2.60 6.04 Baa1 1.41 3.63 1.31 2.6 5.24 4.7 4.97
Morocco 2.60 7.00 Ba1 2.55 2.37 -0.7 1.93 4.6
Philippines 2.60 5.63 Ba3 2.75 3.892 1.53 2.7 5.27 4.1 5.04
Poland 2.60 5.67 A2 0.95 5.75 1.29 1.0 3.60 4.4 5.46
Russia 2.60 7.80 Baa1 1.41 5.4 1.66 11.4 14.00 6.1 15.14
Singapore 2.60 2.02 Aaa 0.68 0.84 -1.1 1.47 1.2
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Thailand 2.60 3.20 Baa1 1.41 3.41 1.08 -0.1 2.48 2.1 2.21

Turkey 2.60 NA Ba2 2.65 7.8 1.55 21.1 23.66 NA 27.31

Table 16: Riskfree rates of emerging countries calculated by three different methods

The above table shows the risk-free rate in emerging markets. I calculated the risk
free rates by the three standard methods. Based on the analysis and the available
data, some inferences can be drawn in properly selecting the riskfree rate

1. The risk free rate calculated by the above three methods vary in their value
by a significant amount. The assumption in the calculation of the risk free
rate is that local investor has access to a global risk free rate. But in many
emerging countries this is not the case (e.g. India, China). The graph below
shows the comparison of risk free rates in a few selected emerging countries.
The most striking difference can be seen in Brazil and Russia. There is
different level of risks associated with the sovereign bonds and local
currency bonds as well as the inflationary environment. So a proper
framework for selected the risk free rate must be in place for emerging

Comparison of Risk Free Rate in Selected EM's

Method 1
Method 2
Method 3
Brazil China India Russia Mexico

Figure 21: Risk-free rate calculated by three different methods shows a wide variance
(Source : Own)
2. Intuitively, priority should be given to local currency denominated bonds as
that has the ability to captures the best risk free rate.
3. When the default spread and CDS spread for a country is not available then
the default spread or CDS spread of a similar rated country can be used as
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a proxy for the sovereign risk

Risk-Free Rate – Choice of Currency

EM Market Currency US Dollar, Euro

Long Term Local Currency Bond for EM’s

No US 10 years treasury bond + Inflation


Long Term Sovereign Bond of EM

Country Available
Local Currency
Bond Default Free Yes

CDS Spreads
Yes Yes Available
CDS Spreads Default Spread No
No No
Available Available
Use CDS of
Reference EM
Rf= Sovereign With same
Rf= Local Currency sovereign rating
Yes Bond Yield – CDS
Bond Yield – CDS
Spread +Inflation

Figure 28: Framework showing the calculation of riskfree rate in emerging markets

(Source : Own)

7.5. Equity Risk Premiums in Emerging Markets: Equity Risk Premium is defined
as the extra compensation that an an investor seeks over a riskfree investment to
compensate him for the risk. The measurement of risk premiums has always been
a very controversial issue. Even in mature markets like the United States, the
measurement and calibration of risk premium has been a topic of considerable
debate. When it comes to emerging countries the problem is much more complex
given the volatility, liquidity and other factors that affect emerging markets.

Damodaran (2002, pg 160) suggests that the estimation of risk premiums for a
mature market varies due to three reasons

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Year Arithmetic Average Geometric Average
Stock - T.Bills Stock - T.Bonds Stock - T.Bills Stock - T.Bonds
1928-2009 7.53% 6.03% 5.56% 4.29%
SE 2.28% 2.40%
1960-2009 5.48% 3.78% 4.09% 2.27%
SE 5.48% 3.78%
2000-2009 -1.59% -5.47% -3.68% -7.22%
SE 6.73% 9.22%
Table 17: Historical Equity Risk Premim Calcluated by three diffe rent methods

1. Time Period Used: Historical Risk Premiums are calculated as the difference
between the returns on stock and riksfree bonds over a given period of time.
The choice of time period has considerable influence on the equity risk
premiums. From the above dataset we can see that how the risk premiums
in the US varied with different time period and hence the selection of the
time period is an important issue.
It has been argued that perception of risk continuously change with the
changes in macroeconomic, social and political event so the best estimate of
the risk premium is given by a shorter time period. The major issue that
arises with using a shorter time period is the high standard error associated
with the returns. In the above table the equity risk premium between 2000-
2009 has a standard error of 6.73% and 9.2%%. With a high standard error
the validity and usage of the data is pretty much questionable.
For emerging markets the time period is very small. Although many of the
emerging countries had stock markets for a pretty long time but most of
these stock market didn‟t have much liquidity and were highly inefficient. As
previous research has shown that most of the market liberalization occurred
around 1990, so effectively we have 20 years of data for emerging markets.
2. Use of risk free rate: The choice of a risk free rate is another issue is
emerging market environment where the bond markets are not that well
developed and there is always a risk of default. This issue has been
addressed in the previous section of this work.
3. Method of Calculation of historical risk premiums: The above table also
shows how risk premiums vary when an arithmetic mean and a geometric
mean is applied to the calculation of the risk premiums. It generally makes
sense to use an arithmetic mean for the calculations for risk premiums but
often it has been found that annual returns are negatively correlated and
the use of arithmetic returns might overstate the premium

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Historical Risk Premiums of Emerging Markets: The proper calculation of historical
risk premiums of emerging markets is very difficult to achieve. For this reason a
number of methods have been suggested to calculate the risk premiums of
emerging markets

1. The country risk premium approach: In the country risk premium approach
a reference mature market like the United States is used and an extra
country risk premium is stacked up to get the required country risk
2. The relative standard de viation approach: In the relative standard de viation
approach the ratio of standard de viation of returns of an emerging market to
that of a de veloped market is calculated and this ratio is multiplied to the
mature market risk premium to get the current market risk premium to get
the emerging market risk premium.

Equity Risk Premium Emerging Market = Risk Premium US × (Standard Deviation

Emerging Market /Standard Deviation US)

This method as popularized by Goldman Sach and is based on the premise

that the ratio between the standard deviation of returns in emerging stock
market is able to capture the degree of riskiness of an emerging stock
market but as (Havery, 1996) argues that many of the emerging stock
markets are illiquid and have different market microstructure which can
result in low standard deviation in markets and high country risk.
3. As we have seen from our analysis of correlation of world returns that
emerging markets have become highly correlated with global markets so a
international equity risk premium might be a good proxy for the
determination of risk premiums in emerging markets.

7.6. Betas:
The concept of beta is an important ingredient of the the standard capital asset
pricing model and the other variants of CAPM that are used in both de veloped and
emerging markets. Beta is defined as the proportion of risk that an investment
adds to the market portfolio. If the beta of a stock is 1.5 then it means that over
the period of calculation the stock moved 1.5 times ahead of the market. It can
also be stated as “For e very 1% return that the market gave over a period of time
the stock gave a return of 1.5%”. Beta tends to capture the systematic risk of the
asset and a higher beta always increases the cost of capital of an asset.

Beta is considered to be a forward looking concept that should have the ability to
capture the sensitivity of a particular stock in reference to a market or economy.
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All present methods I have researched till now are based on the use of historical
data and an estimation period. The main assumption here is that future cashflows
and riskprofile will be similar to the past and hence extrapolation techniques can
be used to get an estimate from the past data.

Betas can be estimated by different methods, but the most common methods
employed to calculate the beta are from a) historical data b) from fundamental
analysis 3) from accounting data of a firm. In the historical method of calculation
the OLS estimates of historical returns are computed against the market returns
by running a regression analysis.


The of the regression signifies the performance of the investment during the
period of regression and as the measure of non-diversifiable risk of a company
which depicts the movement of stock price, in speed and volatility.

The computation of regression betas in emerging markets has many drawbacks.

The constantly changing environment of emerging markets makes the
assumptions that betas are stationery highly controversial. It has been observed
that the difference of beta varies to a large extent with the chosen historical time
series (e.g. 2 Years, 5 Years, etc) and time periods (daily, weekly, monthly, etc).
Research conducted by Pererio (pg123,2002) shows that that betas of emerging
market companies are too low. This observation can be directly related to study
conducted by Dimson(1979) where he states that “Shares that are traded
infrequently have beta estimates that are often severely biased and due to
infrequent trading they appear to be be stable when compared to frequently traded
securities which have high beta estimates”. As we have observed in our study
before how Emerging Markets have illiquid stock markets where only a few large
corporations dominates the stock exchange so historical betas in emerging
markets do not reflect the true nature of the stock. The other problem that has
been observed regarding betas in emerging countries is the yield of negative value.
This might intuitively mean that the stock is moving in the opposite direction to
the market but when it comes to estimating the cost of capital it reduces the cost
of capital by amount lower than the riskfree rate.

The R-Squared of a regression is a fitness indicator of the beta. A high R-Squared

indicates a strong relationship between the stock and the market. In emerging

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markets as pointed out by Pererio(2002), the R-Squared of a stock calculated
against the local stock market tends to be high. The high R-squared in emerging
markets is due to the stock price synchronicity i.e. there are few stocks in the
market that influences the movement of the whole market and their movements
are highly correlated.

These are the major issues with regression betas in emerging markets. From the
above analysis we can say that regression betas can only be used for emerging
countries where there are highly developed stock markets and these markets
behave more like developed countries.

The next type of beta is known as the fundamental beta or the bottom up betas.
The necessary steps to calculate bottom up beta are as follows

1. The first step involves in identifying the business in which the company
2. Develop a peer group of companies that operate in the same line of business
3. Collect the unlevered beta of these companies
4. Compute the weighted average of the computed unlevered betas where the
weights can be operating income.

According to Pratt(Pg-140,2008) bottomup betas provide the best estimate when

the standard error from the regression beta is very high, so taking the mean of
regression beta across the industry reduces the standard error. The major hurdle
in the path of applying this method in emerging market is the fact that in many
emerging markets the universe of companies of similar profile is very limited. This
creates a problem to get the bottom up beta for emerging markets.

Accounting Beta: The beta of a firm can also be calculated from the companies
accounting data. The accounting beta gives the sensitivity of changes in operating
characteristics to that of the industry. The quarterly operating profit of a firm when
calculated against the industry operating profits provides us with the unlevered
beta. As stock market in emerging markets tends to be highly volatile so
accounting betas can give a reasonable estimate. The main disadvantage of
accounting beta in emerging market environment is the problem of accounting
practices in emerging markets and the influence they have on the calculation of
the beta in emerging environment.

From the above analysis we can see that there is no one standard method for beta
calculation in emerging markets and the process is influenced by two broad factors

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1. The market environment i.e. how developed are the stock markets in
emerging countries
2. The number of comparable firms in the emerging country that will influence
the outcome

I propose that we can use a two by two matrix as a framework to determine the
right method for our choice of estimation of beta for emerging markets.

Universe of Comparable Companies (Increases)

Highly developed stock market

Highly developed stock market and large number of companies
but the number of companies in in the comparable universe
a particular universe is not Steps
1. Calculate regression beta for all
present companies in universe of comparable
Development of Stock Market (Decreases)

1. Select the universe from a developed 2. Unlever the betas for the particular
stock market which has similar risk profile sector
2. Unlever the beta 2. Compute the weighted average of the
3. Take the weighted average of the beta betas based on market capitalization or
4. Relever the beta for emerging market operating earnings
company 3. Relever the beta for the particular

Less developed stock market,

Less developed stock market large number of companies in
and number of companies that universe
are available are very small
1. Find reference emerging market with Steps
similar risk profile 1. List of companies which operate in the
2. Select the universe of industries that same line of business are selected
operate under similar environment 2. The industry specific accounting beta is
3.Unlever the sector beta determined
4. Use the weighted average of the betas
5. Relever the beta for the particular

Figure 29: Framework for calculating beta in emerging markets

Source (Own)
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In the above 2 by 2 Matrix I use two parameters to classify the calculation of beta
in emerging markets. On the horizontal axis we use the scale of the universe of
comparable companies (increases along the direction of the arrow) and on the
vertical axis we use the degree of maturity of stock market (which decreases along
the direction of the arrow).

Quadrant 1: This segment denotes countries which have highly developed stock
markets but the number of comparable companies in a particular sector is pretty
limited. Highly developed stock market means that they behave like developed
markets so companies which fall in the same sector in de veloped countries (e.g.
USA) can be used to calculate the industry beta. In a highly globalised world where
there is high correlation among stock markets, this method makes a case for itself
as the systematic risk affecting a particular sector must remain the same.

Quadrant 2: Quadrant two denotes the ideal case where we have de veloped stock
market along with large number of comparable company universe. Due to highly
developed stock market, we can expect that the results of the regression betas
won‟t be as spurious as they tend to be in emerging market environment. So we
can use the regression beta of the sector to get the beta for the firm using the
method stated in the diagram.

Quadrant 3: Quadrant three represent those countries where the stock markets
are not that well de veloped and the number of companies in a specific sector is
very limited. In this case the best option is to find companies in similar emerging
countries which operate in the same business line and the fundamental beta of
that country can be used.

Quadrant 4: Here we have a large number of firms but not so well developed stock
market. Due to the presence of large number of firms we can use the accounting
betas as it will be able to capture the systematic risk that is faced by the company.

7.6.1. Country Beta:

When other variants of CAPM are used like the Global CAPM, ICAMP then one
important constituent of these models is the country beta. Country beta is defined
as the sensitivity of the market compared to that of the world index (like the MSCI
World Ex)

7.7. Adjusting for Company Specific Risk: The main objective of company specific
risk adjustments is to capture the risk associated with company‟s business
structure and the unique risk associated with the company itself. As diversification
cannot be fully achieved in the real world so there is unsystematic risk or

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idiosyncratic risk that affects the valuation of the company. According to Pratt(Pg-
225,2008) there are three areas to concentrate on

1. Size Effect of the Company

2. Control Premiums
3. Illiquidity Discounts

7.7.1. Size Effect:

Research has shown that market capitalization of a company plays an important

role in the determination of the expected return of a stock. Work by Banz(1998)
has shown how bigger firms have considerably less expected returns than smaller
firms in USA. This phenomenon can be attributed to the fact smaller companies
being less established have no proven track record in terms of cre dit ratings,
market share, operations, etc. So investors demand a higher expected return as
compared to larger firms. The study of size effect was carried out in emerging
markets. Roon, Goeij and Pungulesc (2009) has a working paper which explores
the size effect in emerging countries. According to the authors the size of a
company plays an important role in emerging markets also. The market size
accounts to 1% per year in terms of expected returns in emerging countries.

7.7.2. Control Premium and Illiquidity Discounts:

As the research in this area is pretty much limited so making adjustments in the
cost of capital without proper framework is like adding a fudge factor to the above
process. I feel that a much better way to address this issue of company specific
risk is to make the necessary adjustments to the cashflow using probability
weighted scenarios as this will yield a range of values which will much more
beneficial for the decision making process.

7.8. Tackling Inflation in Emerging Markets:

From our macroeconomic analysis we have seen how emerging markets suffer from
high and volatile inflationary environment. When we consider developed markets,
inflation seems to be minor issue and inflation induced error is a small factor in
the valuation process as the rate of inflation is pretty much constant which can
easily be adjusted as a factor in the cost of capital or in the cash-flow of a firm. In
an emerging market environment inflation affects both the financial statements. If
we consider the balance sheet then non-monetary assets such as inventory, plants,
equipments have their value diminished far below their present replacement cost
and same is the case with income statement where deprecation charges are too
low(Koller, 2005).

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The first step involves in indentifying how inflation affects the valuation process.
After going through relevant literature on inflation accounting and capital
budgeting process (Mills,1996), the relevant points can be summarized as follows

1. Due to high inflationary environment growth is overstated, converting

growth back to real terms by factoring it with the annual inflation index
2. Even in case of a steady inflation, error in valuation may cree p in from
increased nominal working capital
3. The challenges one faces to adjust inflation in the cost of capital or the cash
flow: This problem is highly accentuated in highly volatile inflationary
4. The free cashflow of a company is calculated with the basic formula of profit
+ deprecation - reinvestment needs of a company. Overestimation of
reinvestment need may arise due to high inflation.
5. The depreciation value might decrease on the long run due to inflation and
this in turn will affect the tax shield
6. Financial ratios like credit ratios and solvency ratios might be affected due to

The diagram below shows a framework suggested by (Koller, 2005) adjusts the
various parameters in a DCF analysis for inflation.

Estimates Approach
Real Nominal
Operational performance √
Sales √
Capital expenditures √
Investments in working capital √

Income taxes √

Financial statements √

Continuing value √
Table 18: Adjustment of Inflation based on real and nominal approach

(Koller, 2005) also suggest a 5-steps framework to tackle the issues faced with
DCF valuation in inflationary environment.

1. Step 1: Calculation of all operating parameters of the financial statements in

real terms: All historical financial statements the company which is being
evaluated must be converted into current year‟s real-term. Key value drivers

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must be studied and the operating performance of the company must be
forecasted in real terms. In this step future revenues and cash expense must
be calculated, non monetary assets must also be converted to real terms.
2. Step 2: Conversion of financial statements in to nominal terms: Nominal
projections are made by converting real operating projection into nominal
terms by multiplying with the inflation index
3. Step 3: Conversion of the above financial statement into real terms.
4. Step 4: The future free cashflows are projected in both real and nominal
5. Step 5: The value of the firm is calculated using DCF

Although the process might look simple, the main problem arises when forecasting
the future inflation rates and incorporating them in the valuation process. The
best way to address this issue is to use MonteCarlo simulation methods where the
whole projections can be forecasted over different inflation scenarios. After
studying the tool thoroughly I feel that it adds huge flexibility to the descision
making process.

7.9. Applying Simulation to Valuation of Emerging markets:

From the above analysis we see that there are many variables that affect the
valuation model of an emerging market setting. There is only two places where the
adjustments for the risks can be done for an emerging market setting.

1. Through adjustments in the cost of capital

2. Through adjustments in the cash flow

The risks that are not easily captured by the cost of capital should be included in
the cash flow adjustments. Traditional capital budgeting methods used scenario
analysis to improve the decision making process. Simulations can be considered as
an extension of the scenario analysis process where multiple scenarios can be
analyzed and the interaction between the risk variables can be studied to improve
the decision making process

The simplest simulation method that I researched for this piece of work is known
as Monte-Carlo Method17. General scenario analysis conducted in discounted cash
flow can be considered as a deterministic model where fixed relationship between
input and output of the model are assumed and can be solved analytically. When
models are influenced by random events or by chance then they are known as
stochastic models. Stochastic models provide a distribution of probable answers
which is highly beneficial for a investment decision making process.

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There are various risks at play when it comes to emerging markets and most of
these risks are highly random in nature. In situation like this the Monte Carlo
simulation is a highly beneficial tool for forecasting events.

The DCF analysis in an emerging market setting can be carried out through Monte
Carlo Simulation using the following steps:

1. A traditional cashflow model is constructed which has the regular

components : the cashflows, discount rate, and terminal value
2. Uncertain components of income and expenses are analyzed and how they
behave under uncertainty
3. A mathematical form of the random characteristics of the uncertain variable
are chosen (e.g. geometric model, mean reverting model, etc)

From our analysis of macroeconomic enviornment and company specific risk we

can argue that this risks are best handled when adjustements are made to the
cashflow. The effect of these varibales on income and expense parmeters can be
studied using crosssections regressional anslysis and they can be modeled using
step 2 of the above process.

The only disadvantage of a Simulation process is its mathematicla complexity.

Modeling the random charecterstics calls for extensive knowledge of statstics and

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8. Survey of Valuation Process in Emerging Markets:
I think it is very important to know what is being practiced in real world when it
comes to valuation of companies in emerging markets. To gain key insights about
the method that are being followed I had send out a survey of 10 questions to fin
ace graduates in premier B-schools across Europe and Asia. To know more about
the practitioner‟s viewpoint, I send this survey to the corporate finance department
of investment banks, audit firms and business development units of three
multinational companies that makes regular investments in emerging markets.

Analysis of Survey Results:

Question 1: Suppose you are given the opportunity to value a company in

emerging market, what valuation methodology will you prefer?

This question was asked to find out the popularity of the methods used for
valuation in emerging markets. Four option choices were given to the audience.

1. DCF Analysis
2. Multiple Valuation Methodology
3. Comparable Transactions
4. Others

Others 8
DCF Analysis
Comparable 6.61%
Transactions Multiple Valuation
60 Comparable
Valuation …
DCF Analysis 45 49.55% Others

Figure 30: Survey Answers on Valuation Methodology

121 participants responded to this question. I had hypothesized that DCF would
be the most popular choice of valuation method for emerging markets, given its
popularity, but the survey results show that 50% of the respondents are willing to
use Multiple Valuation Methodology. As it was a very open ended question so I feel,
people went ahead with multiple valuation methodology as it is one of the easiest
methods to apply.

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Question 2: On a scale of 1 to 5 how will you rate your comfortability with the
method tha t you use for your valuation 1: Lowest 5: Highest

5 4
4 12 9.68% 6.45% Choice 1
19.35% Choice 2
3 76
Choice 3

2 24 Choice 4
Choice 5
1 8

Figure 31: Survey answers on level of comfortability on valuation

61% of the respondents said that they can more or less use the method that they
know. As almost 70 percent of the respondents are student, so it can be
understood that 3 might be a reasonable choice.

Question 3: If you are valuing a publicly traded company in Brazil, Which

among the given cost of capital will you prefer?

The intention of this question was to see, how people try to calculate the cost of
capital for publicly traded firms in emerging countries. The options that were given
to the users are

1. Company Specific Cost of Capital

2. Industry Specific Cost of Capital
3. Rule of Thumb
4. Other

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Other 0

Company Specific
Rule of Cost of Capital
Thumb Industry Specific
Cost of Capital
Specific Cost 60 Rule of Thumb
of Capital
Company 48.39% Other
Specific Cost 48
of Capital

Figure 32: Survey Results on Cost of Capital

48% of respondent prefer to use the company specific cost of capital for emerging
markets and 60% use industry specific cost of capital. A industry specific cost of
capital is a good approximation for emerging markets, but there are two problems
associated with this issue. First, due to the restricted size of the universe and
variation in company size will bias the cost of capital. Second, firm specific risks
are very important determinants of cost of capital in emerging market, so company
specific adjustments are required.

Question 4: If you are valuing a Private Entity, Which Choice among the given
Cost of Capital will you prefer?

As valuing private entity in emerging market is not an easy task at hand so it is of

prime importance what people think about the cost of capital in emerging market
environment. Again I had offerd the following choices to the users

1. Company Specific Cost of Capital

2. Industry Specific Cost of Capital
3. Rule of Thumb
4. Other

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Investment Valuation in Developed and Emerging Economies

Other 4

3.13% Company Specific

15.63% Cost of Capital
Rule of Thumb 20 31.25% Industry Specific
Cost of Capital
Specific Cost of 64 Rule of Thumb
Company Other
Specific Cost of 40

Figure 33: Survey Results on Cost of Capital (2)

This time also 60% of the respondent preferred to use the industry specific cost of
capital. The possible reason for the choice of this option is that it is comparatively
difficult to company specific information in emerging markets so a industry
specific cost of capital is used.

Question 5: If you are valuing a Technology Startup in Emerging Market, Which

Choice among the given Cost of Capital will you prefer?

Other 8
6.39% Company Specific
Cost of Capital
Rule of Thumb 24 Industry Specific
42.49% Cost of Capital
Rule of Thumb
Industry Specific
Cost of Capital
Company Specific
Cost of Capital

Figure 34: Survey Results on Cost of Capital (3)

The answers of this question surprised me the most. I had expected that the
respondents would prefer a industry specific cost of capital or rule of thumb but
for a new technology startup, calculating the company specific cost of capital is
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Investment Valuation in Developed and Emerging Economies
extremely difficult that too in emerging market environment. The only reason why
such a choice was made can be attributed to the fact the respondents perceive
each company based on individual risk profile and add an additional factor which
is specific to the company.

Question 6: How do you prefer to determine the cost of equity in an emerging

market environment?

The choice of answers provided for the following questions were

1. The Standard CAPM

2. The International CAPM
3. Multifactor Models
4. Others

Others 8
6.39% The Standard CAPM

36 The International
38.34% CAPM
International Multifactor Models
The Standard
48 15.97%

Figure 35: Survey Results on calculation of cost of equity

48% respondent still prefers the Standard CAPM for calculating the cost of equity
in an emerging market environment. The popularity of the CAPM can be attributed
to its simplicity and to the fact that all major text book of finance generally discuss
the CAPM and multifactor models like the arbitrage pricing model.

Question 7: In your valuation of an emerging market company, what will be the

choice of your risk free rate?

The choice for answers for the questions were

1. US Risk Free Rate

2. Local Currency bond yield adjusted for country default spread
3. Sovereign bond yield adjusted for Inflation and Default
4. Other

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Investment Valuation in Developed and Emerging Economies

US Risk Free Rate


Sovereign bond yield 19.17%
adjusted for Inflation Local Currency
and Default bond yield
31.95% adjusted for
Local Currency bond country default
yield adjusted for spread
country default …
38.34% Sovereign bond
yield adjusted for
US Risk Free Rate Inflation and

Figure 36: Survey Result on Riskfree rate

From our analysis we have seen that, due to the development of local currency
bond markets in many of the emerging countries, the popularity of local currency
bond as the riskfree rate adjusted for country default spread has become the most
popular choice. The respondents confirm this fact with 38% voting in favor of the
Local Currency bond yield in favor of risk-free rate.

Question 8: Which Beta will you use for valuation of an Indian Listed Company

1. Regression Beta calculated against the local stock exchange

2. Fundamental or Sector Beta
3. Accounting Beta
4. Others

Regression Beta
Others 4 calculated against
the local stock
15.97% exchange
Accounting Beta 20 Fundamental or
Sector Beta
Fundamental or
Sector Beta
28.75% Accounting Beta
Regression Beta
calculated against 60
the local stock …

Figure 37: Survey Results on Riskfree rates

The most common choice here was the regression beta calculated against the local
stock exchange. Although the Indian stock exchange is the largest in the whole

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Investment Valuation in Developed and Emerging Economies
world in terms of the number of companies listed but it has problem with market
liquidity where out of 5000 companies listed only top 50 companies constitute
almost 85 percent of the total market capitalization. A regression beta might not
reflect the true risk of the stock against the portfolio.

Question 9: How do you prefer to tackle the problem of Inflation in your valuation
1. Make necessary adjustments to the cash flows
2. Make adjustment to the discount ra te
3. Others

Others 8 Make necessary

adjustments to the
cash flows
Make adjustment to
Make adjustment
48 47.92% the discount rate
to the discount rate 38.34%

Make necessary
adjustments to the 60
cash flows

Figure 38: Survey Results on Calcluation of Inflation

From our analysis we have seen that inflation is an important aspect of valuation
in emerging markets. Here again we see that 60 % of the respondents are in favor
of adjusting inflation in the process of cashflow which along with simulations can
be highly beneficial in the investment decision making process

Question 10: Where do you think is the biggest hurdle that you faced while valuing
an Emerging Market Company?

1. Availability of Company specific Information

2. Calculation of Equity Risk Premium
3. Determination of Cost of Capital
4. Others

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Investment Valuation in Developed and Emerging Economies

Others 12 Availability of
Company specific
9.58% Information

Determination of Calculation of Equity

24 Risk Premium
Cost of Capital 19.17%

Calculation of Determination of
Equity Risk 36 Cost of Capital
28.75% Others
Availability of
Company specific 52

Figure 39: Survey results on difficulty levl of valuation.

52% responded that availability of company specific information is one of the

biggest hurdle in the valuation of emerging market companies. I studied the
accounting statements of a few Indian companies.

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Investment Valuation in Developed and Emerging Economies
9. Conclusion:
The field of investment valuation is a constantly evolving field where the changing
dynamics of the world affects the process of valuation. Indeed, valuation is more of
an art than hard science so flexibility and adaptation are two important aspects.
This research paper brought out some interesting facts about investment valuation
in emerging markets.

First, through our macroeconomic analysis we saw how the emerging markets
differ from that of developed markets. Contemporary issues like financial depth,
inflation, interest rates and exchange rate which affect a valuation process are
contrastingly different when compared to developed nations. Due to global
integration and increased level of trade, financial depth in many of the emerging
markets has increased drastically in the last decade. High Inflation and Foreign
Exchange Volatility is still an important issue in emerging markets which can have
profound influence on the process of valuation.

Second, I looked at the different vehicles of investment in emerging markets and

the common set of issues that affects investment valauation process. Majority of
these problems can be bundled into two main areas. First, the determination of
cost of capital and second, adjustments of the different risks affecting an
investment to the valuation process. From here, I went on to study the general
valuation process in de veloped markets and what are the problems that one have
when they are applied to emerging markets. I found that there has been a
remarkable improvement in the correlation in world returns as compared to
previous studies. This suggests that capital markets around the world are now
more globally integrated so concepts like global CAPM makes much more sense.
But as many emerging markets differ in their market microstructure so to apply a
correct model for calculating the cost of equity is highly important. I developed a
market scorecard to tie all the variables of financial markets that affect the
determination of cost of capital into a coherent framework which can be applied to
calculate the cost of equity.

Third, I also focused on other issues like: determination of riskfree rate, equity risk
premium and calculation of beta in emerging markets and tried to find the best
practices that can be applied to determine these parameters. Issues such as size
effect and control premiums are still open ended issues in valuation where there is
tremendous scope for further research. Instead of just adding a fudge factor to the
discount rate, I argued the best way to address these issues is to model their effect
in the cash-flow process. Tackling inflation in the valuation process is another
important factor in emerging market valuation. The present DCF method as
suggested by academics can be viewed as a two dimensional process where
different scenarios of inflation can be modeled into the cash flow process. I
strongly feel that simulation methods like Monte Carlo Simulation can add a whole
new dimension to the process and throw much more light in the investment
valuation as well as decision making process.

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10. Research Implications and the road ahead…
The above concluded study provides some outlook on investing in emerging
markets and the process of investment valuation.

- As shown through research, the past decade has seen an increased

correlation among world markets. This means that investors seeking to
add emerging market stocks as portfolio diversification will see little
benefits. But many of these countries run on different economic cycle.
Future research should focus more to take advantage of business cycle as
diversification benefits
- Broad macroeconomic policies and factors still play a very important role
in emerging market valuation. Future research can find ways to integrate
these macroeconomic risks in the valuation process with a much more
multidimensional approach.
- From our research we saw that many emerging countries have high stock
price synchronicity, low turnover ratio. These problems mainly arise due
to company specific risks, corporate governance, etc. Increasing
operational efficiency, improvements in corporate governance process is
bound to act as major drivers of value in emerging market companies
- Process to capture timely information in emerging markets should be
studied , so that investors, appraisers can benefit from them
- An area of strong focus for research should be application of stochastic
simulations and probabilistic based scenario analysis to the valuation of
companies in emerging countries as it will provide more insights to a
decision making process.

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Investment Valuation in Developed and Emerging Economies

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