Pricing Country Risk – Pictures Of Global Risk – Part III

Pricing Country Risk – Pictures Of Global Risk – Part III by Aswath Damodaran, Musings on Markets

In my last two posts, I looked at country risk, starting with an examination of measures of country risk in this one and how to incorporate that risk into value in the following post. In this post, I want to look at an alternative way of dealing with country risk, especially in investing, which is to let the market price of country risk govern decisions.

Pricing Country Risk

If you are not a believer in discounted cash flow valuations, I understand, but you still have to consider differences in country risk in your investing strategies. If you use pricing multiples (PE, Price to Book, EV to EBITDA) to determine how much you will pay for companies, you could assume that the levels of these multiples in a country already incorporate country risk. Thus, you are assuming that the PE ratios (or any other multiple) will be lower in riskier countries than in safer ones.

It is easy to illustrate the impact of risk on any pricing multiple, with a basic discounted cash flow model and simple algebra. To illustrate, note that you can use a stable growth dividend discount model to back into an intrinsic PE:

Dividing both sides of this equation by earnings, we derive an intrinsic PE ratio:

The PE ratio that you should expect to observe in a country will be a function of the efficiency with which firms generate earnings (measured by the payout ratio), the expected growth in these earnings (g) and the risk in these earnings (captured by the cost of equity). Holding the growth and earnings efficiency constant, then, you should expect to see lower PE ratios in countries with higher risk and higher PE ratios in safer countries. You can use the same process to extract the determinants of price to book ratios or enterprise value multiples and you will arrive at the same conclusion.

Equity Multiples

To see how well this pricing paradigm works, I started by looking at PE ratios by country in July 2015. To estimate the PE ratio for a country, I tried three variants. In the first, I compute the PE ratio for each company in the country (where it was computable) and then average across these PE ratios. To the extent that there are small companies with outlandish PE ratios in the sample (and there are many), these ratios will be skewed upwards. In the second, I compute a weighted average PE ratio across companies, with the weights based upon net income. This ratio is less affected by outliers, but it excludes money losing firms (since the PE ratio is not meaningful for these companies). In the third, I add up the market values of equity across all companies in the market and divide by aggregated net income for all companies, including money losing companies, i.e., an aggregated PE ratio. This ratio has the advantage of including all listed firms in a market but big money losing firms will push this measure up. The picture below summarizes differences in PE ratios across the world, with the weighted average PE ratio as the primary measure, but with the all three reported for each country.

via chartsbin.com

As you can see PE ratios are noisy, with some very risky countries (like  Venezuela) trading at high PE ratios and safe countries at lower values, not surprising given how much earnings can shift from year to year. For the most part, the riskiest countries are the ones where stocks trade at the lowest multiple of earnings.

To get a more stable measure of pricing, I computed price to book values by country, again using the simple and weighted averages across companies and aggregated values and report the weighted average Price to Book in the picture below:

via chartsbin.com

As with PE ratios, there are outliers and Venezuela still stands out with an absurdly high price to book ratio, incongruous given the risk in that country. For the most part, though, the PBV ratio is correlated with country risk, as you can see in this list of the 28 countries that have price to book ratios that are less than one in July 2015:

Weighted average PBV ratio in July 2015

Enterprise Value Multiples

Both PE and PBV ratios are equity multiples and may reflect not just country risk but also variations in financial leverage across countries. To remedy this problem, I look at EV to EBITDA multiples across countries:

via chartsbin.com

Looking at this map, it is quite clear that there is much less correlation between EV/EBITDA multiples and country risk than there is with the equity multiples. While it is true that the lowest EV/EBITDA multiples are found in the riskiest