9.1 INTRODUCTION. The principles of valuation do not change when you are
valuing emerging market companies. In particular, the value of an asset or a business
is the present value of the expected cash flows, discounted back at a rate that reflects
the riskiness of the cash flows. It is true that many inputs that we take for granted in
developed markets, such as risk-free rates may not be easily accessed in emerging
markets, and other inputs, such as risk parameters and premiums, are much more dif-
ficult to estimate because of the paucity of historical data. In addition, the informa-
tion provided in financial statements may fall well short of what we need to know to
value a firm. We will begin by considering the estimation issues associated with dis-
count rates first, then examine cash flow estimation, and close with some general
caveats about emerging market valuation.
9.2 ESTIMATING DISCOUNT RATES. While there are several competing risk and
return models in finance, most of them require three inputs to come up with an ex-
pected return. The first is a riskless rate, which acts as a floor on your required return
and measures what you would make on a guaranteed investment. The second is a risk
premium, which looks at the extra return you would require as an investor for in-
vesting in the average risk investment. The third is a risk parameter or parameters
(depending on the model you use) that captures the relative risk of the specific in-
vestment that you are evaluating.
(a) Risk-Free Rate. Most risk and return models in finance start off with an asset that
is defined as risk-free and use the expected return on that asset as the risk-free rate.
The expected returns on risky investments are then measured relative to the risk-free
rate, with the risk creating an expected risk premium that is added on to the risk-free
rate. But what makes an asset risk free? And what do we do when we cannot find such
an asset?
(i) Requirements for an Asset to Be Risk Free. An asset is risk free if we know the ex-
pected returns on it with certainty (i.e., the actual return is always equal to the ex-
pected return). Under what conditions will the actual returns on an investment be
equal to the expected returns? There are two basic conditions that have to be met. The
first is that there can be no default risk. Essentially, this rules out any security issued
by a private firm, since even the largest and safest firms have some measure of de-
fault risk. The only securities that have a chance of being risk free are government
securities, not because governments are better run than corporations, but because
they control the printing of currency. At least in nominal terms, they should be able
to fulfill their promises. There is a second condition that riskless securities need to
fulfill that is often forgotten. For an investment to have an actual return equal to its
expected return, there can be no reinvestment risk. To illustrate this point, assume
that you are trying to estimate the expected return over a five-year period and that you
want a risk-free rate. A six-month Treasury bill rate, while default free, will not be
risk free, because there is the reinvestment risk of not knowing what the treasury bill
rate will be in six months. Even a five-year treasury bond is not risk free, since the
coupons on the bond will be reinvested at rates that cannot be predicted today. The
risk-free rate for a five-year time horizon has to be the expected return on a default-
free (government) five-year zero coupon bond. This clearly has painful implications
for anyone doing corporate finance or valuation, where expected returns often have
9 • 2 VALUATION IN EMERGING MARKETS