are changing rapidly over time, it is dangerous to base value estimates on informa-
tion that is this old. Instead, use more recent information. While you have the option
of using quarterly reports in the United States, there are many emerging markets
when accounting statements are provided semiannually or annually. When valuing
firms in these markets, analysts may have to draw on unofficial sources to update
their valuations.
(ii) Correcting Earnings Misclassification and for Differences in Accounting Standards.
The expenses incurred by a firm can be categorized into three groups:
1.Operating expenses are expenses that generate benefits for the firm only in the
current period. For instance, the fuel used by an airline in the course of its
flights is an operating expense, as is the labor cost for an automobile company
associated with producing vehicles.
2.Capital expenses are expenses that generate benefits over multiple periods. For
example, the expense associated with building and outfitting a new factory for
an automobile manufacturer is a capital expense, since it will generate several
years of revenues.
3.Financial expenses are expenses associated with nonequity capital raised by a
firm. Thus, the interest paid on a bank loan would be a financial expense.The operating income for a firm, measured correctly, should be equal to its rev-
enues less its operating expenses. Neither financial nor capital expenses should be in-
cluded in the operating expenses in the year that they occur, though capital expenses
may be depreciated or amortized over the period that the firm obtains benefits from
the expenses. The net income of a firm should be its revenues less both its operating
and financial expenses. No capital expenses should be deducted to arrive at net in-
come. It is at this stage that differences in accounting standards come into play. Prac-
tices vary widely across countries on how items are categorized. As noted above,
leases are treated as operating expenses in most emerging markets. In addition, the
treatment of research and development (R&D) expenses, which are really capital ex-
penses, varies across countries. In some countries, the practice is similar to the
United States and all R&D expenses are treated as operating expenses. In other coun-
tries, some R&D expenses are capitalized. If you are doing discounted cash flow val-
uation, you often have to recategorize these expenses to come up with a measure of
true operating income. If you are comparing earnings multiples across companies in
different markets, you have to correct for differences in accounting standards before
making comparisons.
(iii) Correcting for Earnings Manipulation. Firms try to manage their earnings and in
some cases manipulate them. While this is true for both developed market and emerg-
ing market companies, the weakness of accounting standards and the laxity of the
legal system make earnings management and manipulation a much more serious
problem in emerging markets. To the extent that firms manage or manipulate earn-
ings, you have to be cautious about using the current year’s earnings as a base for
projections. In particular, you have to look at two issues:
1.Extraordinary, recurring and unusual items.The rule for estimating both oper-
ating and net income is simple. The operating income that is used as a base for9 • 32 VALUATION IN EMERGING MARKETS