Apr 21, 2020
“During the COVID lock down, the only active button in my body is my imagination”- Garfield the Cat
Stipulating on the WACC approach, ROE is considered a key and popular determinant in PE valuation whether utilized in mergers and acquisitions or IPO’s or even direct investments transactions. Theoretically, think of ROE as a triangle with its three main heads: stock market return/ premium, sector beta and RFR. As a result of the pandemic outbreak globally, most of the stock markets witnessed massive selling trends leaving most of stocks prices and indices in the red area. In the US, the 1 year return for S&P 500 and DIJA recorded -13% and -8.7% respectively. As for the Asian markets, Nikkei and STI recorded -10.3% and -21.9% respectively. The British FTSE recorded a declining impact of -22.5% as well. Some of the emerging and frontier markets witnessed a hard impact such as EGX30 recording -32% for the same period. Hence, plugging in any of these market premiums will yield negative ROE making it difficult to conclude an accurate valuation.
On top and above, most world economies will experience a diminishing economic growth if not negative as a result of the pandemic procedures of partial and full lockdown. Thus, calculating terminal values based on negative growth rates will not also be applicable. Most investors are reverting to their hard powder reserves to complete their open commitments and positions in some PE transactions. All of these market circumstances combined raise an essential question: is it possible to conduct an accurate PE valuation? If yes, what are the parameters to do so?
Actually to answer this question, let’s unleash our imagination like Garfield the cat. In my humble opinion, an accurate PE valuation is doable. What are the parameters? Two main pillars, country risk premium and foreign currency direction. For the sake of argument and for illustrative purposes, I will use the US equity market especially S&P 500 returns and correlate it to the Egyptian equities spectrum and currency to calculate the Egyptian ROE. Nevertheless, this illustrative methodology could be applicable to any other emerging or frontier market subject to two conditions.
First, its economy will be witnessing a positive growth. Like the rest of the world, Egyptian market is subject to partial lock down. As an impact of the pandemic outbreak, Egyptian economy is expected to grow at a rate of 2% according to conservative estimates. Secondly, its local currency is currently selling at a discount to its equilibrium value and expected to appreciate. Now, how to evaluate an Egyptian equity when EGX30 return is -32%? Simply calculate the ROE in the US market and add Egypt’s country risk premium to the equation as tackled by many researches. Under such methodology, Egypt’s country risk premium to be added as independent factor and not mixed or multiplied with US Sector Beta. Hence, assuming all Egyptian equities is subject to the same country risk as per the following equation:
ROE US= US RFR+ US Sector Beta *(S&P500 1 year return – US RFR) + Egypt’s country risk premium
US RFR= 3 months T/B of 0.14%
S&P500 1 year return = -13%
US Sector Beta = the beta of the US sector similar to the sector of the Egyptian equity
Egypt Country Risk Premium= 10%
0<US Sector Beta<1
Incorporating the numerical data in the calculations, leads to two important conclusions.
First, such approach is only applicable to Egyptian defensive equities where its equivalent US sector records a beta of less than 1 such as power, utility, food processing and telecommunications. Thus, such method could be partially utilized in evaluating Vodafone and STC contemplated acquisition deal. Also, such defensive equities in the Egyptian market will be easier to promote for international investors in the upcoming period.
Secondly and, depending on the Egyptian Target sector beta, the global stock market return will be chosen. For example, defensive equities betas below 0.5 could tolerate up to 32 % declines in stock market returns. On the other hand, defensive equities betas above 0.5 but below 1 could tolerate less market declines by a range of 5%-10%. Nevertheless and under all scenarios, the country’s risk premium will compensate positively for the declining stock markets return. Subsequently, we have to convert the US ROE into the local currency denominated ROE. This could be done by utilizing the international interest rate parity, yet allowing for some minor adjustments to cater for foreign currency discounts / premiums as per the following:
(1+Egypt ROE)/ (1+US ROE)= (1+FC premium)
Egypt ROE=((1+US ROE)*(1+FC premium))-1
Noting that the current USD/EGP spot rate is EGP 15.75, the Egyptian Pound is expected to appreciate vis-à-vis the USD by a premium of 13%. This is based on a USD forward price of approximately EGP 14. Now, this approach will yield positive trailing EV/ EBITDA multiples by plugging in the positive Egyptian ROE into our PE valuations beside the positive growth rate of 2%. Even under unlevered and no growth scenarios except for terminal value, this approach might still generate lucrative valuations depending on the Egyptian equity sector and its equivalent beta in the US.
Finally, an adjusted ROE approach catering for country’s risk premium might be appealing to some investors stemmed from some factors. First, it suits economies that will rely more on its local industries to face the partial halt in the global trading movement as a result of COVID-19 lock down. Secondly and despite the sharp declines in EGX30, its standard deviation is still considered low partially due to illiquidity reasons. Hence, some of Egyptian equities beta could be distorted and relying on its US equivalent will be more appropriate.
The successful marketing of Egyptian equities will rely to great extent on preserving Egypt’s foreign currency reserves to strengthen its local currency and ultimately achieve a positive ROE. This could be done by mimicking the Russian and Chinese hedging mechanism applied few weeks ago in bilateral trading. Both countries opted to conduct trading transactions in Ruble and Yuan, hence, preserving their FC balances. Anyways and in all cases, time will tell if such approach is a real opportunity or an imaginary myth.
This article was first published on TalkMarkets.com on 18/04/2020
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