By Leslie Harrison
Foreign firms require special consideration of accounting differences, currency fluctuations, and cost of capital estimates.
The valuation of foreign businesses or corporate subsidiaries follows the same principles and methods of valuation—no surprises there. Certain issues, however, such as differences in accounting treatment, the impact of currency fluctuations, and assessment of country/political risks, need special consideration.
Reorganizing financial statements for consistency
The first steps in any valuation exercise—foreign or domestic—is to restate the financial statements to ensure consistent treatment of accounting items and proper calculation of cash flows. Common adjustments to financial statements include reclassification of leases; normalization of unusual or one-time items; and segregation of assets and liabilities into operating and non-operating categories.
For foreign firms following different accounting frameworks, such as the International Financial Reporting Standards (IFRS) or a local Generally Accepted Accounting Principles (GAAP), particular attention must be paid to differences between the accounting principles used. For instance, the treatment of revenue recognition, inventory treatment, pension accounting, and expense capitalization can vary significantly between IFRS and U.S. GAAP. These differences may cause the foreign firm’s reported profits and asset values to diverge materially.
Understanding differences in accounting treatment is important when reorganizing financials statements. Without proper adjustments, performance metrics and valuation multiples would not be comparable across firms.
Forecasting cash flows in foreign currency
To value a firm operating in a foreign country, analysts first forecast cash flows in the foreign currency. This approach better captures local economic conditions, inflation rates, and competitive dynamics.
Once the projections are complete, two methods are available for discounting the foreign-currency cash flows to present value in the domestic currency. Regardless of the method used, these should yield the same intrinsic value for the foreign entity, so long as all monetary assumptions remain consistent.
- Spot-rate method: In this method, the projected foreign currency cash flows are discounted at the foreign cost of capital. The resulting present value of foreign currency cash flows is then converted to domestic currency using the spot exchange rate.
- Forward-rate method: Here, projected foreign currency cash flows are first converted into domestic currency cash flows using the relevant forward exchange rates. These domestic currency cash flows are then discounted at the domestic cost of capital.
In the forward-rate method, because most currencies do not have forward exchange rate quotes beyond 18 months, analysts often estimate forward exchange rates for the remainder of the forecast period by applying interest rate parity theory. Interest rate parity theory states that foreign exchange rates tend to follow the ratio of expected inflation rates between two currencies. The formula is expressed as:
Where,
Critical to performing an accurate valuation, when constructing cash flow projections and determining the cost of capital of different currencies, practitioners must ensure consistent application of inflation rates, interest rates, and forward exchanges rates across currencies. Differences in inflation assumptions embedded in the cash flow projections and those used in the cost of capital would result in over- or under-stated valuation figures.
Estimating foreign currency cost of capital
The process of estimating the cost of capital for a foreign firm is the same as for any firm, but particular attention is given to ensure that the monetary assumptions within the cost of capital are consistent with the cash flows it is intended to discount. In particular, the expected inflation rate to be included in the foreign currency weighted average cost of capital (WACC) should align with the expected inflation rate included in the foreign currency cash flows.
Practitioners have a few methods for estimating the cost of capital for a foreign firm. The most rigorous method involves constructing the cost of capital from foreign components—using sovereign bond yields, equity risk premium, and capital structure observations from the foreign market.
A more simplistic, and arguably more common, method starts with a domestic cost of capital which is then adjusted by incorporating (i) a country risk premium to reflect the political/economic risks present in the foreign jurisdiction; and (ii) an adjustment to the equity risk premium to account for the higher (or lower) volatility of the foreign equity market relative to the domestic equity market.
A third method utilizes a global market portfolio to compute beta and equity risk premiums, (rather than relying on a local market portfolio). The increasing globalization of investments and the free flow of capital across international markets strengthen the case for the use of a global market. More importantly, however, from a valuation perspective, the case for using a global market portfolio is most evident when considering the lack of diversification often found in local markets—particularly those in smaller countries. These local markets can be concentrated in a few companies or select industries, and the lack of diversification in the local market may yield inappropriate (i.e., biased) beta and equity risk premiums.
The value of professional expertise
In practice, navigating all the accounting, currency, and risk adjustments requires experienced judgment. A professional valuation appraiser contributes up-to-date market data and analytical rigor to each step—from normalizing foreign financial statements and modeling foreign currency cash flows to calibrating a risk-adjusted discount rate.
The specialized expertise helps avoid common pitfalls (e.g., improper adjustment to accounts, inconsistent inflation assumptions, etc.) and ensures that the valuation methodology employed is sound. Engaging a qualified valuation professional provides assurance that these cross-border complexities will be handled thoroughly and credibly, yielding a valuation result that decision-makers can trust.