How Country Risk Affects Fair Valuation of Equity Securities

November 29th, 2010 by hackel Leave a reply »

The past few years out-sized swings in the prices of financial securities have been caused, no doubt, by changes to credit and risk, which form the basis of the cost of equity capital. Yet, despite security analyst and investors continued fixation on  the quarter up the road’s reported earnings, it is evident it is the ability to create value ( through enhancement of free cash flows) and reduction in cost of capital that should stand front and center for investors looking to enhance their portfolio returns.

Value-adding firms are so defined from their free cash flow based return on invested capital historically exceeding their cost of capital. In turn, the cost of capital must take into account all metrics and information that affects prospective free cash flows. These items include everything from revenue growth (which includes success of new products and marketing), input price volatility, debt and interest expense, lawsuits, patents, acquisitions, credit rating, pension status, healthcare cost, and everything in between.

It is therefore the ability to spot changes to cost of capital that brings superior performance over the long term, not a firm’s free cash flows exceeding expectations in a given quarter. Cost of capital takes into account the ability of the firm to return free cash flows, although it is targeted at its stability and predictability.

Given recent events in Korea and Europe, we take a look at sovereign risk, an important component of CT Capital’s cost of equity capital model

Sovereign risk must be accounted for as part of cost of equity. The conditions under which a company operates and has major facilities or markets will influence cash flows, consistency measures and leverage. As we have seen, energy exploration companies have had their operations nationalized, while many companies have been harmed by high inflation outside the United States. If an entity receives a significant portion of its cash flows from a non-US geography, the risk to those cash flows must be assessed, with a mark up to cost of capital, where appropriate. This is especially true for companies operating in emerging markets, where a mark-up to cost of capital is always made, even if the cash flows from those areas are currently strong and without incident.

All possible threats and the entity’s sensitivity to any related factors must be considered, including sanctions, tariffs, threat of retaliation of US Government actions, stability of currency, exchange control, inflation, threat of its neighboring countries, restrictions, etc. As tensions rose along the North/South Korean border, many very large Korean based stocks saw declines of greater than 5%, despite hostilities going back for several years with no end in sight to dictatorship rule.

Investors normally participate in foreign ownership through direct purchases on the local exchange, through a mutual fund or ETF, or via ADRs or Regulation S securities.

Example- SK Telecom Co. Ltd. (SKM)

In the CT Capital credit model, we have adjusted all Korean stocks cost of equity capital upward by a full percentage point; as such there have been no Korean stocks included in our model portfolio for many years. A one percentage point increase represents a substantial penalty.

SK Telecom, South Korea’s leading telecom provider, has been a strong generator of both cash flow from operating activities and free cash flows. The company has three reportable segments: cellular, fixed line, and other. There are some noticeable differences between Korean and US accounting methods, such as subsidiary consolidation rules, but they are immaterial to this analysis. Its growth in free cash flows has not been as strong as its operating cash flows owing to continuing large capital spending programs. The CT Capital cash flow model recaptures part of the excess spending, such that, when the standard definition of free cash flow of capital spending minus capital expenditures is used, the firm would appear to have generated just $763MM during its last fiscal year, while CT Capital judges the firm as having generated closer to $ 1.4 billion, including our making adjustments to the firm’s reporting methods.

Without the adjustment to sovereign risk, SKM’s cost of capital would be 7.45%, below that of the S&P Industrials, resulting from its large market share, cash flows, value-creating decisions, and strong credit. Yet, with the mark-up for sovereign risk, its cost of equity moves up to 8.45%. One might ask: Isn’t 1% an off the cuff number?  To this I answer, that might be true, but given the political context, such an adjustment appears eminently reasonable, and brings to light a cost of capital closer to reality than having made no, or an unrealistically low or higher adjustment. Recent volatility in the shares of affected companies bears out this thinking.

With the adjustment, what is the resultant impact to current fair value?

For this, we set up the following sensitivity analysis to reflect scenarios illustrating various risk assumptions including that for sovereign risk. For purposes of this example, we will assume cost of equity is correct except for that of the refection of sovereign risk. We also show fair value, given a blending of risk based on the probability of a wide range of political outcomes.

As shown, what would otherwise be an undervalued investment becomes a close call when sovereign risk is considered.  We have therefore concluded there is not sufficient enticement, given a 7.8% potential return versus 8.45% cost of capital (which is the required return given the risks), to induce us to recommend purchase of SKM shares.


For additional information, including a complete discussion related to the analysis of credit quality and risk see Security Valuation and Risk Analysis, McGraw-Hill, 2010.

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Disclosure: No positions

Kenneth S. Hackel, CFA
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010).


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