Pursuing Lasting Progress in Emerging Markets®

On the Uses and Abuses of Discount Rates

When investors search the world for opportunity, do they value a dollar of profit from Indonesia six times more than a dollar from South Korea? I doubt they do; I know I do not. Nonetheless, large discrepancies of this sort can arise when investors rely heavily on discount rates in valuation models to determine the relative attractiveness of foreign equity markets.

In general, I do not subscribe to models that rely on widely disparate discount rates to rank or prioritize assets within the same asset class. I know from experience that it is difficult to determine discount rates with accuracy and precision, especially in foreign markets. As a consequence, such rates are often prone to measurement error, subjective bias, or both. Well-intentioned analysts sometimes nudge discount rates to support otherwise factual arguments. It is tempting to do so: discount rates are the dominant assumption in most valuation models, and thus a relatively small adjustment can produce a markedly different result. Consequently, a supposedly objective framework can be “tweaked” to support a predetermined conclusion. Whatever the intent, discount rates are one of the primary means by which distortion or bias can creep quietly into a model and undermine its integrity.

The table below, from a prominent brokerage firm, offers an example where discount rates do not serve investors well when comparing relative opportunities. It presents “fair” multiples for price-to-book and price-to-earnings ratios based on the Gordon growth model. The values in the table are based on three key inputs for each country, visible in the leftmost columns: the cost of equity (which serves as the discount rate), the return on equity, and forecast growth.

Emerging Market Valuations Based on Gordon Growth Model (Using Conventional Discount Rates)
Estimated Cost of Equity (COE ≈ Discount Rate) Assumed Return on Equity1 (ROE) Forecast Nominal Growth (G) Price/Earnings at end of Q1 2011 "Fair" Price/Book2 "Fair" Price/Earnings3
Indonesia 14.0% 20.0% 13.0% 13.1 7.0 36.3**
India 15.3% 18.0% 14.7% 14.3 5.5 28.9
Thailand 9.6% 13.2% 8.1% 11.7 3.4 25.0
Philippines 9.7% 11.0% 8.7% 13.5 2.3 22.3
Malaysia 9.8% 12.9% 7.1% 10.9 2.1 16.5
Mexico 11.3% 15.6% 8.5% 14.1 2.5 16.3
Brazil 12.6% 16.0% 10.3% 10.2 2.5 15.6
China 14.0% 15.3% 13.0% 11.0 2.3 15.3
Columbia 11.0% 14.0% 8.2% 17.8 2.1 14.8
Czech Republic 9.9% 19.8% 4.1% 10.9 2.7 13.8
Egypt 13.2% 16.4% 10.6% 9.4 2.2 13.7
Chile 11.7% 12.5% 10.5% 15.3 1.7 13.6
Morocco 11.0% 17.9% 6.0% 15.5 2.4 13.3
South Africa 12.0% 15.7% 8.5% 10.9 2.1 13.0
Taiwan 9.0% 9.5% 6.2% 12.2 1.2 12.4
Peru 14.1% 22.0% 9.5% 12.0 2.7 12.2
Turkey 14.2% 18.1% 10.5% 9.9 2.1 11.3
Russia 13.9% 14.9% 11.8% 6.9 1.5 9.9
Hungary 15.5% 16.3% 5.9% 9.5 1.1 6.6
South Korea 12.7% 10.8% 7.3% 9.8 0.6 6.1**
**Nearly 6x Difference
Source: UBS and Seafarer.

The results in the right-hand columns are tabulated correctly, but are nonetheless suspect. They imply that an average Indonesian asset should enjoy an earnings multiple that is six times higher than its South Korean counterpart. The premium on book value is even higher, with the Indonesian multiple eleven times that of Korea. In my view, these results defy both common sense and practical reality. The discount rates in the table are a key culprit: though derived in a manner consistent with financial theory, they yield dubious results. By setting the discount rate for Indonesian assets at only 14%, just above the assumed growth rate, the model flatters Indonesian valuations. Likewise, by setting the discount rate at nearly twice the Korean growth rate, Korean assets are penalized.

When evaluating different opportunities across a given asset class, I prefer to avoid techniques where disparate rates drive the end result. Whenever possible, I prefer to utilize a standardized rate across the opportunity set, akin to a “hurdle rate” or a “minimum acceptable rate of return.” If there is a structural difference between two sub-groups within an asset class (i.e., a group of fast-growing assets versus a slow-growing group), I might subdivide the class into two tiers to accommodate. However, I would still utilize a standard hurdle rate within each tier.

In my view, a standardized hurdle rate offers three benefits. First, it forces the investor to make an explicit assessment of future risks and opportunity costs. This contrasts with the conventional approach, which tends to derive the cost of capital from inputs based on historical data. History is not always the best guide. Periods of extended volatility (or tranquility) may not accurately represent the future. For example: at this moment, the “risk free rate” (the yield on the U.S. ten year treasury bond) may be distorted by the temporary policies of the U.S. Federal Reserve. In comparison, a hurdle rate forces the investor to anticipate the future cost of capital, regardless of what historical conditions convey.

A second benefit of a standardized rate is that it improves the transparency and objectivity of the valuation process. When using a fixed rate, it’s much harder to “lean” toward a pre-determined conclusion.

The third benefit is the most important: a standardized hurdle rate forces investors to carefully study the unique economic characteristics of each asset. Rather than make broad generalizations determined by tenuous rate differentials, investors are obliged to analyze business models in closer detail. In the process, they are forced to learn more about the underlying asset, thus sharpening any assumptions associated with it. For example: in the table above, I would question whether Indonesia’s profitability (second column from left) and its growth rate (third column) will remain so high, justifying its large premium over Korea. Those questions are tangible; answers can be produced with fact-based research; and the findings convey meaningful information about the asset’s expected performance. By comparison, tinkering with differentials in discount rates seems like an artificial exercise, one more likely to mislead than enlighten.

By no means do I turn my back on decades of financial research. I understand very well the importance of discount rates to the valuation process, especially in the determination of the intrinsic value of a given asset. My complaint centers on top-down allocation frameworks that tacitly rest upon discount rates, and the tenuous assumptions behind them. Seemingly immaterial differentials in rates can generate sweeping differences in the perceived attractiveness of assets, leading investors to ignore potentially viable opportunities without proper scrutiny. Discount rates are useful when valuing a single asset, but in my opinion, they should not be a primary determinant in the allocation between multiple assets.

Andrew Foster
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
  1. Based on 3 year trailing average.
  2. Based on Gordon growth model: Fair P/B = (ROE - G) / (COE - G)
  3. P/E = P/B / ROE