The relationship between value and instability

Political unrest and changes to governments and regimes are deeply unsettling for investors. Such occasions bring instability and uncertainty and this invariably leads to cost.

The commercial impact of political change can include expropriation of assets by a new regime, the renegotiation or dismissal of contracts as the dust settles and a new order replaces the old.

Often the legal and financial aspects of these events are felt for years afterwards. A good example is the work undertaken by lawyers and accountants following the Iraqi invasion of Kuwait in 1991. Forensic accounting teams were engaged for more than 10 years afterwards in an attempt to quantify the commercial impact of the invasion on Kuwaiti businesses in order to claim compensation.

Estimating the value of a company, or alternatively assessing the quantum of loss suffered by a company, in an unstable jurisdiction requires a detailed understanding of the financial impact that political unrest or uncertainty can have on rates of return required by a hypothetical rational investor.  

In short, a company operating in an unstable country tends to be worth less than a company operating in a stable country, because it is more difficult for investors to forecast the future cashflows of the company. There is always a risk that the political and economic security may adversely affect the company’s future profitability.

Value is usually assessed with reference to a company’s ability to generate cashflows and/or profit. The estimation of cashflows can be straightforward if, for example, the future cashflows are linked to a long-term contract as in the case of a utilities company.

These cashflows are then discounted at a rate which reflects the time value of money. The discount rate is far more problematic, and should reflect an investor’s required rate of return to compensate for the risk of him investing in that venture, at that time.

In simple terms, discount rates include an assessment of a risk-free rate, a premium for investing in equities, plus a number of specific risk adjustments to reflect, for example, country and political risk.

The building blocks of discount rates are generally referenced to local stockmarkets and/or bond data. When there is civil unrest, such benchmarks may no longer be reliable. For example, the MSCI Egypt index lost half its value in 2011 during the Arab Spring. Estimates taken at a snapshot in time may be inconsistent with long-run historic averages and a poor basis for forecasting. The market capitalisation of companies at this time will be depressed and earnings multiples distorted if based on historical earnings prior to the time of unrest.

One way of addressing an unstable domestic economy is to assess discount rates and forecasts in a reference currency (eg US$). However, it is important to maintain consistency. Discount rates based on US measures incorporate future expectations of inflation in the US. This can be addressed by converting local currency forecasts into US$ at forward rates which also incorporate inflation expectations. The key is to ensure consistency between the cashflows and the discount rate.

Finally the date of the valuation is key, as hindsight is generally excluded from such calculations. For example, in Kuwait the discount rate on 1 August 1990 would, based on valuation theory, be lower than that on 2 August 1990, the date of the Iraqi invasion (unless it is determined that the invasion was reasonably foreseeable on 1 August 1990). A similar parallel can be seen in valuations around the time of the Lehman Brothers collapse, which heralded the start of the credit crunch.

Ultimately the key theme is consistency; consistency between cashflows and discount rates; consistency between reference data (almost always historical) historical long-run averages, and the forecast information available. This remains a challenge for valuers and forensic accountants in regions where the only constant is change.

Susan Blower is a senior manager at BDO