DATA2017UPDATE3:CRACKINGTHECURRENCYCODE

AswathDamodaran

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Backtothebeginning:Theintrinsicvalueequation

• Inintrinsicvaluation,thevalueofanassetisthepresentvalueofitsexpectedcashflows,discountedbackatariskadjustedrate.

• Therewasatimeinthenotsodistantpast,whereanalystscoulddotheiranalysisintheirlocalcurrenciesandcarelittleornotatallaboutforeigncurrencies,howtheymovedandwhy.

• ThiswasparticularlytrueforUSanalystsinthelasthalfofthelastcentury,wheretheUSdollarwastheunchallengedglobalcurrencyandtheUSeconomybestrodetheworld.

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TheCurrencyEffect(ornon-effect)

¨ Inintrinsicvaluation,currencychoicesaffectboththecashflowsandthediscountratesthatyouuseinvaluation:

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TwoSimpleCurrencyPropositions

• Thefirstisthatcurrencyisameasurementmechanismandthatyoushouldbeabletovalueanycompanyinanycurrency,sinceallitwillrequireis restatingcashflows,growthratesanddiscountratesinthatcurrency.

• ThesecondisthatinarobustDCFvaluation, yourvalueshouldbecurrencyinvariant.Putdifferently,thevalueofPetrobrasshouldbeunchanged,whetheryouvaluethecompanyinnominalBrazilianReais ($R),USdollarsorEuros.

¨

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CurrencyEstimationQuestions

1. ExchangeRateForecasts:Tobeabletovaluecompaniesthatoperateindifferentcurrencies,youhavetobeabletoforecastexchangeratesforlongperiodsforward.

2. DiscountRates:Tobeabletoswitchfromvaluingcompaniesinonecurrencytoanother,youhavetobeabletoestimatediscountratesforacompanyinanycurrency.

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ExchangeRateForecastingforValueInvariance

¨ Ifyouwanttomakeyourvaluationscurrencyinvariant,andinflationiswhatsetscurrenciesapart,thewaytoestimateexpectedfutureexchangeratesistoassumepurchasingpowerparity:

¨ Evenifyouhavestrongcurrencyviews,itisbesttokeepthemoutofyourcompanyvaluations,sinceyourvaluationconclusionswillthenbejointeffectsofyourcompanyandcurrencyviews.

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DiscountRates:Twowaysofestimatingcurrency-specificdiscountrates

Aswath Damodaran

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¨ Groundup:Inthisapproach,youstartbyestimatingtheriskfreerateinthelocalcurrencyandthenbuilduptothecostofequityandcapital,usingwhateverbuildupmechanism(betas,riskpremiums)thatyouuseinanyothercurrency.

¨ DifferentialInflation:Inthisapproach,youestimateyourcostofequityorcapitalinthecurrencythatyoufeelmostcomfortableworkinginandthenusedifferentialinflationtoconvertitintoadifferentcurrency.

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RiskFreeRate1:GovernmentBondRates

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

SwissFranc

Japane

seYen

Euro

DanishKrone

CzechKo

runa

Swed

ishKrona

Taiwanese$

BritishPou

ndNorwegianKron

eHK

$Canadian$

BulgarianLev

IsraeliShekel

KoreanW

onSingapore$

US$

ThaiBaht

Australian$

Croatia

nKu

naCh

ineseYuan

NZ$

HungarianForin

tRo

manianLeu

PolishZloty

ChileanPeso

Malyasia

nRinggit

PhillipinePe

soIcelandKron

aVietnameseDo

ngIndianRup

eePe

ruvianSol

ColombianPeso

Indo

nesia

nRu

piah

MexicanPeso

PakistaniRup

eeRu

ssianRu

ble

SouthAfricanRand

Turkish

Lira

BrazilianReai

KenyanShilling

NigerianNaira

Vene

zuelanBolivar

Ten-yearGovernmentBondRatesbyCurrency- January1,2017

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RiskfreeRate2:GovernmentBondrate,netofdefaultspread

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Japane

seYen

Croatia

nKu

naCzechKo

runa

SwissFranc

BulgarianLev

Euro

DanishKrone

Taiwanese$

PakistaniRup

eeSw

edish

Krona

ThaiBaht

HungarianForin

tBritishPou

ndRo

manianLeu

VietnameseDo

ngHK

$IsraeliShekel

KoreanW

onNorwegianKron

eCanadian$

Singapore$

US$

ChineseYuan

PhillipinePe

soPo

lishZloty

Australian$

Malyasia

nRinggit

NZ$

ChileanPeso

IcelandKron

aIndianRup

eeCo

lombianPeso

PeruvianSol

Indo

nesia

nRu

piah

RussianRu

ble

MexicanPeso

SouthAfricanRand

BrazilianReai

Turkish

Lira

KenyanShilling

Vene

zuelanBolivar

NigerianNaira

Ten-yearGovernmentBondRates,netofDefaultspread(basedonsovereignrating)

RiskfreeRate DefaultSpreadbasedonrating

Green:Defaultspreadforcountry(basedonrating)Red:GovernmentBondrate– DefaultSpread

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Riskfree Rate3:DifferentialInflation

¨ Youstartwithariskfreerateinacurrencywhereyoubelievethatthegovernmentbondrateisareliablemeasureoftheriskfreerate(andthenaddtothisnumberthedifferentialinflationratebetweentheUSdollarandthelocalcurrency.¤ LocalCurrencyRiskfreeRate=US$RiskfreeRate+(Expected

inflationinlocalcurrency– ExpectedinflationinUS$)

¨ Thisisanapproximationthatworksreasonablywellwhenlocalcurrencyinflationislow(closetotheUSdollarinflationrate)butthemorepreciseversionofthisformulation:

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Riskfree Rate4:SyntheticRiskFreeRate

¨ Start with the Fisher equation¤ RiskfreeRate=ExpectedRealInterestRate+Expectedinflationrate

¨ Youcanaugmentthisequationwiththeassumptionthatlongtermrealgrowthinaneconomywillconvergeonthelongtermrealinterestrate.¤ ExpectedRealInterestRate=ExpectedRealGrowthRate¤ SyntheticRiskfreeRate=ExpectedRealGrowthRate +Expectedinflationrate

¨ IfyouareabletoestimateexpectedinflationandrealGDPgrowthforthelongtermforaneconomy,theriskfreerateforthecurrencyofthateconomywillbethesumofthetwo.

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CostofCapital+InflationDifferential

¨ Ifyoustartwitha riskfreerateinalocalcurrencyandbuilduptoacostofcapitalusingequityriskpremiumsanddefaultspreads,oftenavailableonlyindollar-basedmarkets,youareeffectivelyassumingthatriskpremiumsareabsolutenumbersthatdon'tchangeastheriskfreeratechanges.

¨ Ifyouwanttoscalethemallup,hereisthesimplesolution: