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VALUING COMPANIES IN EMERGING

MARKETS
 Tags: Darin Bifani (https://www.onetoonecf.com/en/tag/darin-
bifani/), Emerging markets (https://www.onetoonecf.com/en/tag
/emerging-markets/), M&A strategy (https://www.onetoonecf.com
/en/tag/ma-strategy/), valuation (https://www.onetoonecf.com/en/tag
/valuation/)

In our financially interconnected world where there are few restrictions on where
M&A deals can be carried out, one major practical transaction challenge that
investors and companies face is the valuation of companies
(https://www.onetoonecf.com/en/increasing-firm-value-in-an-ma-deal/) and assets
in emerging markets.

(/en)
Emerging market valuation can be difficult due to several reasons, including:

– the key revenue and cost drivers of a company’s business may be highly exposed
to microeconomic or macroeconomic variables that are rapidly changing

– there may be a limited number of transactions in a market involving a particular

asset or company type which creates a high degree of uncertainty about what an
asset or company is worth

– there may be country risks, such as political or social risks, which create
significant uncertainty about how the business environment a company operates
in will change in the future.

These difficulties often lead to situations where companies or assets are

significantly overvalued or undervalued, creating unrealistic investment return
expectations, investor and company tensions that negatively affect a company’s
performance and, most importantly, inefficient patterns of capital allocation and
repayment that can restrict business and economic growth.

This article briefly defines the concept of an emerging market in the valuation
context, discusses some emerging market valuation challenges and sets forth
guidelines that companies and investors can use when they face valuation
challenges in these markets.

What is an Emerging Market?

While the term “emerging market” is often used as a shorthand way to refer to
countries that are entering a phase of significant economic growth, from a
financial valuation perspective the concept of an emerging market is often not so
straightforward.

The reason for this is that every country is in reality comprised of many different
markets, and these markets are in a constant state of flux with some markets
growing, others in a state of relative stability and other markets in a phase of
decline. Even with respect to markets that are in a phase of decline in terms of
total market size or profit margins, the application of new technologies may cause
these markets or sub-markets to enter new periods of high growth.

For the purpose of valuation, it is therefore helpful to identify three types of

emerging markets:
– the first type of emerging market is a country that is undergoing a phase of
rapid economic growth. This is growth which is significantly better than historical
 (/en)
growth rates and has been sustained for at least several years. To provide one
example of a classic emerging market, since 2002, Ethiopia’s annual GDP growth
rate has exceeded 10% many times

– the second type of emerging market is a sub-market in an economically mature

market, such as the United States, that is currently undergoing a phase of rapid
economic growth. An example of this type of market is green vehicle technology

– the third type of emerging market is a market which is the result of the
combination of two markets, such as the financial sector and technology,
producing the fintech market.

These emerging market types highlight the point that regardless of how a market
is labelled, the actual market realities a company operates in can be highly
dynamic and complicated.

Valuation Challenges in Emerging Markets

Valuing assets and companies in emerging markets presents significant

challenges, both from market-based as well as cash flow-based valuation
approaches (https://www.onetoonecf.com/en/the-real-value-of-your-business/).

Market-Driven Valuation Approaches

A common way for companies to be valued is to derive valuation metrics from the
market, such as based on the relationship between company sale prices and
company revenues or EBITDA. However, in emerging markets there can be very
little transaction history regarding a company or asset type, so these metrics may
not exist

Cash Flow-Based Valuation Approaches

Another common way for companies to be valued is to forecast the company’s

future cash flows and then discount the value of those cash flows by a discount
factor based on risk. In emerging markets, however, this can be very challenging to
do because first, as suggested above, there may be not enough transaction history
to extract a discount factor. More importantly, emerging markets often experience
high degrees of volatility and accordingly cash flows and risk levels can be highly
susceptible to change, either moving to more stability, lower risk and lower growth
rates or becoming significantly riskier and at times even collapsing.
Emerging Market Valuation Principles

(/en)
To face the challenges of emerging market valuation, it is helpful to keep the
following points in mind:

– Definition of Market. The first point is to accurately define the market that the
relevant company or asset is in. It is often the case that a company in an
ostensibly highly stable market is actually positioned in a sub-market experiencing
significant growth which may be not be reflected in the valuation metrics
applicable to transactions in the broader market. Similarly, a company in a highly
volatile emerging market may actually have a business model which is highly
stable and insulated from a significant amount of market volatility, such as a
company in an emerging market whose sales are based on long-term contracts
with highly stable buyers.

– Definition of Company Relationship to Market Drivers. The second point is to

analyze the relationship of a company’s business model to market drivers. For
some business models, such as construction, there tends to be a high correlation
between the company’s business model and a country’s GDP growth. Other
business models, however, may benefit during periods of macroeconomic volatility,
such as those based on debt renegotiation or selling discount products and
services.

– Use of Other Markets as Valuation Reference Points. In the absence of

sufficient transaction history in a market for valuation purposes, it is useful to use
metrics in other markets as a starting point. While different markets can have very
different realities, many business models of companies in the same industry, even
if they are located in different jurisdictions, are structurally similar which can help
define income and cost structures and profitability.

Once this is done, it is then necessary to compare the company to be valued with
companies in the reference market to see whether the reference valuation
parameters should be adjusted upwards or downwards. Some key factors to
consider in this comparative analysis are:

– The profitability of the company to be valued compared with companies in the

valuation reference group;

– Risks to the company’s current revenue and cost structure compared with risks
that affect the company’s valuation reference group;
– Size of a company’s potential growth market compared with companies in the
valuation reference group; and
(/en)
– Ability of a company to take advantage of that growth market compared with
companies in the valuation reference group, based on such factors as strength of
the companies’ leadership and management teams, the nature of competitors in
the market, barriers to market entry and regulatory factors that promote or restrict
competition.

Conclusion

Due to the integration of global capital markets and low economic growth rates in
mature markets, investors will continue to look for investment opportunities in
emerging markets and companies in emerging markets will continue to search
more developed markets for investment capital.

While investing across markets at different stages of development presents

significant valuation challenges, through a careful analysis of market realities and
comparing the structure and prospects of a company’s business model to
companies in a reasonably selected valuation reference group, it is possible to
obtain a valuation of a company or asset in an emerging market that is fair for
investors as well as target companies. This is necessary to match investment
capital with investment opportunities and create continually more efficient
markets.

This article was written by Darin Bifani (https://www.onetoonecf.com

/es/compraventa-empresas-quien/who-equipo-onetoone/?id=608), ONEtoONE
Partner in Chile
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