Does the value of a company depend on which country it operates in? The answer is yes, and here is why.
Business value is about risk and return. In other words, what makes a business valuable is how much money it makes given an acceptable level of risk. Investors, including business owners, look to put their money into business ventures that promise reasonable returns, both on their money and of their original investment.
Why business values differ by country
When sizing up business risk, the country’s economic and political conditions matter. Consider operating a company in a well run, developed economy such as Western Europe or North America. Political situation and the laws governing commerce are well understood and enforced. Financial markets are highly efficient and liquid. So if you invest in a public company, you can unload your holdings in a few moments and move your money into a different investment.
The situation in less developed or politically troubled countries may be very different. The rule of law may be confusing or hard to discern. Exporting your money may well be fraught with difficulties or be very expensive. Bribes and protection rackets could plague the unwary investors. Your erstwhile business partners could turn out to be plain crooks.
Global financial markets abhor such instability. If the investors as a whole see systemic problems in a given country, they usually vote with their feet and take their investments to safer havens.
If you are adventurous, you may give investment in an emerging economy a shot. After all, risk and reward go together.
Unsurprisingly, the global investment community has a way to assess just how risky a business investment is in a given country. Consider how the discount rate for business valuation is built up. This discount rate captures the risk of your business investment. Note the equity risk premium, or ERP for short, in the equation.
Equity risk premium and country risk premium
For advanced, stable economies such as the USA or Western Europe, the ERP is measured by the returns on a major equities index, such as Standard and Poor 500 (S & P 500). The countries rated by the major credit agencies at the top of the scale get the Aaa rating. What this means is that investing in such countries is about as good a bet as investing in the broad portfolio of companies covered by the S & P 500 index.
In other words, business investment in the USA, Canada, or Germany is no more risky than the equities market as a whole. Such advanced economies do not have any additional risk premium by country.
However, business values in less developed or stable countries is more risky. If you choose to invest in a company in many South American or Middle Eastern countries, your investment carries an additional country risk premium. How high the premium is depends on the risk spread of the particular country.
Example: business values in advanced vs developing countries
How does this country risk premium affect business values? Lets take an example of two companies, each generating $300,000 in net cash flows and growing at an annual rate of 5.47%. Both companies are debt free, so their cost of capital is just the equity discount or cap rate.
Let’s further assume that both companies are small, under $50M in market capitalization, and offer professional engineering services. The first company, based in the USA, has the equity discount rate made up of these parts:
|Element of risk||Value, %|
|Risk free rate (based on US 10 year Treasury yields)||2.5%|
|Equity risk premium||5.7%|
|Country risk premium||0%|
|Small company size premium||11.59%|
|Industry risk premium||0.46%|
|Company specific risk premium (CSRP)||4.1%|
|Equity Discount Rate||24.35%|
This gives the total equity discount rate of 24.35% and capitalization rate (cap rate) of 18.89%.
The second company in our example is based in Argentina, the country rated B3 by Moody’s. The country risk premium is around 9.3%, which gives us the total discount rate of 33.65% and cap rate of 28.19%.
Difference in business valuation by country
We next use the constant growth direct capitalization business valuation method to figure out what each company is worth. Remember, the only difference in this scenario is the country risk premium. Here are the results:
Business value of the US-based company
Valuation result for the Argentina-based company
As you can see, the difference in business value is considerable. Given a choice, any rational investor would go for the US company due to its lower risk. The Argentina based company would have to throw off more cash increasing its returns in order to compensate the investors for its higher risk.