In today’s global economy, an established business might consider expanding its revenue base by acquiring or merging with a company in an emerging market. These markets — for example, in Brazil, China, India, Mexico, South Africa and Turkey — provide tremendous growth potential. But they also come with significant risks. So, obtaining reliable business valuations is an essential part of due diligence in emerging-market M&As.

Capturing opportunities and risks

A nuanced valuation approach is required for companies in emerging markets, which generally are countries experiencing rapid economic growth and increasing industrialization. These companies face challenges related to market inefficiencies and operational risks that typically aren’t present in countries with more advanced economies. Other differences can also significantly affect the value of an emerging-market company. Specifically, valuation pros evaluate the following key factors:

Local market conditions. Examples include market maturity, potential customer base, cultural trends and norms, competitive landscape, industry trends, and the tax and regulatory environment.

Political risks. These include the risks of government intervention and trade sanctions, the stability of the current regime and its policies, and possible threats from internal opposition parties and neighboring countries.

Economic risks. Factors such as inflationary trends, interest rates, and currency and exchange rate volatility must be carefully considered.

Operational barriers. Examples include regulatory restrictions on foreign ownership, labor market constraints, and limitations in infrastructure and supply chains.

Access to capital. Assessing the company’s ability to raise funds, refinance debt, or expand operations is critical.

Corporate governance standards. These include the applicable accounting rules and the country’s laws governing shareholder, intellectual property, and contractual rights.

Emerging-market companies also usually don’t provide financial statements that conform to U.S. Generally Accepted Accounting Principles — or other recognized financial reporting frameworks. So, valuators must scrutinize the quality of financial reporting and internal controls, and the alignment between shareholders and management.

Incorporating key factors into the valuation equation

In emerging-market company valuations, the market approach may not be appropriate because of the difficulty in finding reliable comparables. And the cost (or asset-based) approach may not adequately capture the growth potential of these companies.

Instead, discounted cash flow (DCF) analysis is typically used to estimate an emerging-market company’s value. This method involves two key components: 1) the subject company’s future economic benefits (typically cash flows) and 2) a discount rate based on the investment’s risk. Both components may be affected by the key factors identified above.

For example, market conditions (such as market maturity, the competitive landscape and tax rates) may be taken into account when forecasting the target company’s future cash flows. On the other hand, economic and political risks may be incorporated into the discount rate through a “country risk premium.” This premium reflects the additional returns investors expect for the increased risk of operating in that country.

When forecasting cash flows and estimating discount rates, valuators avoid double-counting opportunities and risks. For example, an economic risk already factored into the target company’s forecasted cash flows shouldn’t also inflate the discount rate.

The quality of the target company’s financial information is another important consideration when applying the DCF method to emerging-market companies. Historical financial results are frequently used to forecast future cash flows. Given that financial reporting in emerging markets may lack the transparency of reporting in more advanced markets, additional due diligence is often required. This helps ensure that the inputs used in a DCF model are complete and free from errors and fraud. Otherwise, the valuation could be misleading or inaccurate — potentially causing the acquirer to overpay.

Consult a valuation pro

For businesses looking to expand into emerging markets, it pays to hire a business valuator to help kick the tires of a prospective M&A deal. A thorough, accurate valuation is essential when evaluating the asking price and negotiating the deal’s terms. Moreover, an expert’s in-depth analysis can provide insights to help navigate the complexities of operating in a foreign market and enable informed investment decisions.

(This is Blog Post #1661)