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The Practice of Investment Valuation in Emerging Markets: Evidence from Argentinaa

Luis E. Pereirob

Abstract

This paper discusses the challenges of applying traditional valuation techniques to emerging markets, and reports on how CFOs, financial advisors and private equity funds meet those challenges in Argentina, a major Latin American emerging economy. On many fronts, our findings show that there is substantial alignment with U.S. valuation practices. We find that: (a) discounted cashflow techniques like NPV, IRR and payback are very popular among corporations and financial advisors; (b) the CAPM is the most popular asset pricing model, yet it is frequently modified to account for country-specific risk; (c) capital budgeting analyses are performed in U.S. Dollars by non-Dollar companies; (d) financial advisors tend to apply U.S. betas to the emerging market, yet they rarely adjust betas for cross-border asymmetries; and (e) corporations tend to disregard the effects of small size and illiquidity. We provide tentative explanations for our findings.
JEL: G31. Keywords: International capital budgeting, emerging markets, valuation.

Published in: Journal of Multinational Financial Management 16(2), 160-183, April 2006.

I am grateful to Bob Bruner, Ben Esty, Campbell Harvey, Marc Zenner, Omar Toulan, Jaqueline Pels, Andrew Powell, Ernesto Schargrodsky, Federico Sturzenegger and participants at the 2002 conference on Valuation in Emerging Markets held at the Darden Graduate School of Business, University of Virginia, and participants at the research seminar of the Business School, Universidad Torcuato Di Tella, for helpful observations. The useful comments of the editor, Ike Mathur, and of an anonymous reviewer are also gratefully acknowledged. Universidad Torcuato Di Tella, Saenz Valiente 1010, C1428ATG, Buenos Aires, Argentina. Tel: 5411 4783 3112; Fax: 5411 4783 3220; E-mail address: lpereiro@utdt.edu (L.E.Pereiro).

Electronic copy available at: http://ssrn.com/abstract=1874151

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1. The issues at stake

Traditional valuation techniques do not provide much guidance as to how they should be applied to emerging markets. The existence of market efficiency in emerging markets is highly debatable since these markets are small, concentrated, and prone to manipulation; as a result, the straight application of the classical CAPM for defining the cost of equity capital is controversial. If the analyst chooses to apply a relative valuation framework, value multiples from local comparable companies and transactions tend to be scarce and unreliable; if foreign benchmarks are used to solve the problem, it is not clear how these should be adjusted for cross-border asymmetries. Last, empirical data on the value effects of firm-specific features (like size, control and illiquidity) may be scarce or plainly unavailable. As a result, practitioners must ponder hard on how to adapt to emerging markets the recommendations of finance scholars.

How do investors and analysts deal with such complex issues? Unfortunately, the literature provides little empirical evidence on their practices. The matter is not trivial, since in recent years substantial amounts of foreign direct and financial investment have flowed to emerging economies. A case in point is Argentina, one of the top three economies in Latin America, where investment activity exploded in the 1990s as a result of rapid economic and financial liberalization. Pereiro (2002a) reports that, over the 19911997 period, foreign direct investment inflows to the country surpassed $ 37 billion, while stock market capitalization increased at a compounded annual rate of 21.4%. The goal of this paper is precisely to unveil the valuation practices of corporations, investment advisors and private equity funds in this emerging market.

Electronic copy available at: http://ssrn.com/abstract=1874151

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2. Survey structure

This paper is structured as a piece of clinical researchan empirical work in which a relatively small number of events are examined intensively (Tufano, 2001)by surveying a small group of qualified respondents in the target country. First, it explores the valuation techniques and asset pricing models used by financial practitioners, and uncovers the methodologies used to compute riskfree rates, betas and market risk premiums. Second, it analyzes the ways by which analysts calibrate financial data originally obtained for developed markets, to the local market. Last, the paper surveys the treatment of size and illiquidity effects.
1

Our sample included fifty five respondents: thirty one corporations, five financial advisors, six private equity funds, three banks, and three insurance companies (Table 1 displays the complete list). The first group of respondents, henceforth called corporations, was comprised of manufacturing and non-financial services firms. Table 1 shows that 84% of this sub-sample was composed of international firmseither local-origin firms with substantial international involvement or local subsidiaries of foreign multinational corporations (MNCs). Only 23% of this sub-sample were local publicly held firms. Untabulated analysis showed firms in this sub-sample to be highly diverse in terms of size, industry, liquidity of the stock and origin of capital: annual revenues ran from $18 million to $5.5 billion, with an average of $506 million; 42% of the sample had revenues between $100 million and $1 billion a year. Average headcount was 1,966 employees per firm; and 48% of the sample employed more than 500 individuals per firm. In summary, the corporations sub-sample represented 18 different industries, combined annual revenues of more than $17 billion, and employed more than 68,000 people; we deem it as reasonably representative of the largest, most complex and systemically most sophisticated companies operating in Argentina.

Throughout this paper, by local market we will mean the emerging market under discussion. All monetary figures are expressed in U.S. Dollars.

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Put Table 1 about here

The second group of respondents included financial advisors and private equity funds (PEFs). The goal was to compare the behavior of this sub-sample against that of corporations, and check for differences in the degree of analytic sophistication and other possible biases. Finally, we got responses from six banks and insurance firms; for such a small sub-sample, results should be considered as merely suggestive.

As to the survey instrument, we designed and pilot-tested a written questionnaire which was sent by standard mail to 800 firms, all members of the Argentine Institute of Financial Executives (IAEF), and simultaneously by e-mail to 350 companies of the same sample. We obtained 25 spontaneous and usable answers (3.13% of the population). In a second stage, 240 companies belonging to the original universe were contacted again by phone and through e-mail; they were selected for their substantial scale of operations and were deemed as excellent candidates for the survey exercise. This stage added 30 further usable cases, to arrive at a total of 55 casesabout 7% of the originally contacted sample. Such a response rate is somewhat smaller than the rates obtained in the U.S. surveys by Graham and Harvey (2001, 9%) and Trahan and Gitman (1995, 12%). The survey results, obtained by August, 2000, appear in Table 2.

Put Table 2 about here

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3. Survey results

3.1. Valuation techniques

In the U.S., the constant preaching of financial economists on the advantages of discounting valuation techniques has paid off: while such techniques were used by only a minority of practitioners in the 1970s, they are now employed by a majority of corporations and advisors (see e.g. Mao, 1970; Schall et al., 1978; Gitman and Forrester, 1977; Moore and Reichert, 1983; Stanley and Block, 1984; Bierman, 1993; Trahan and Gitman, 1995; Bruner et al., 1998; Graham and Harvey, 2001). The internal rate of return (IRR) was a primary valuation tool in the U.S. in the 1970s (Gitman and Forrester, 1977) and is now still as popular as NPV. However, nondiscounting techniques like payback and multiples are also frequently used at present (Graham and Harvey, 2001).

Our survey uncovers that the influence of mainstream financial economics thinking on Argentine practitioners is as widespread as in the U.S.: DCF and NPV are widely used as primary valuation tools; IRR and payback are also popular (Items 1, 2 and 3 in Table 2).

We next explored whether practitioners adjust for project-specific risk in the cashflows or in the discount rate. Several authors (e.g., Lessard, 1996; Copeland et al., 2000; Shapiro, 2003) have suggested that country-related risks like the expropriation of assets or the unexpected movement of exchange rates should be factored directly into cashflows, not into the discount rate, since such risks are diversifiable from the perspective of the global investor. Lessard (1996) has further argued that country-related risks may be countered by contracting international insurance whose costs can be precisely computed and added to or subtracted from the cashflow as risks evolve

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over time. On the other hand, adding a constant risk premium to the discount rate would be inappropriate, since country risk may vary with time (Bruner et al., 2003).

Yet it may be extremely difficult to envisage the precise effects of country risk on a companys expected cashflow and, as a result, the analyst may lean instead toward a discount rate adjustment. Pettit et al. (1999) argue that, at most U.S. MNCs, the standard method for estimating discount rates for overseas investment projects is precisely to add a foreign risk premium to the firms domestic cost of capital. This is intended to reflect the political and economic risks associated with operating in an unfamiliar country. Along the same line, Keck et al.s (1998) survey of 131 financial analysts shows that, with the exception of taxeswhich are more easily modeled into cashflowsidiosyncratic risk corrections tend to be introduced into the discount rate. Graham and Harveys (2001) survey reports, in turn, mixed results: out of the respondents introducing project-specific risk adjustments (31% of the sample), 28% adjusted for risk in the rate, 31% in the cashflows, and 41% in both .
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Our survey shows (Item 4) that Argentine corporations tend to adjust for project risk in the cashflow (53%) rather than in the discount rate (34%). In turn, financial advisors display the reverse trend: 45% adjust in the cashflows, and 64% in the rate. Also, most Argentine practitioners use a discount rate to account for the cost of capital (Item 5), as is the case for the majority of U.S. corporations and advisors (Bruner et al., 1998). Finally, the majority of our respondents use growing perpetuity models in the computation of terminal values; yet the use of multiples for that purpose is also very frequent among advisors and funds (Item 6)as it is in the U.S. (Bruner et al., 1998).

Relative valuation via multiples is not very popular among Argentine corporations (Item 7). This may be explained by the fact that the technique requires the availability of a sound set of

The risk adjustment categories mentioned in Graham and Harveys (2001) survey were: interest rate risk, foreign exchange risk, GDP or business cycle risk, risk of unexpected inflation, size (small firms being riskier), commodity price risk, term structure risk, distress risk, market-to-book ratio, and momentum (recent stock price performance).

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comparables which may be scarce or simply unavailable in the local market. As an alternative to local comparables, analysts may simply apply easily available U.S. multiples; our survey shows that this is a frequent practice among Argentine financial analysts and funds, but not so among corporations (Item 8).

Yet, if U.S. data is to be applied to an emerging market, cross-border corrections of multiples are mandatory, for similar companies may be valued differently in different geographic markets. First, major differences exist among countries regarding accounting reporting practices; it makes little sense to compare the earnings level of firms operating in different economies if those differences are not properly known. Second, national stock markets may have widely different perceptions on the value of the same group of assets; these differences may be due to country risk differentials perceived among economies, or to the simple fact that different markets may value differently the same managerial/company attributes. In short, there is a country-related effect on company value that cannot be resolved just by normalizing financial statements (Solnik, 1996).

A cross-border correction may be achieved by regressing multiples against macroeconomic variables (Damodaran, 2002), or via simple linear adjustments that use the averages of value multiples for the emerging and the U.S. stock markets (Pereiro, 2002a). Yet our survey shows that cross-border corrections of multiples are infrequent among Argentine corporations: only 33% of firms apply them (Item 8). Adjustments are quite popular, in turn, among advisors and funds (64%).

Real options valuation is infrequently used in Argentina (Item 9). This matches the evidence from developed markets: Copeland (2002) finds that only 27% of U.S. practitioners use real options valuation. And in Barrow et al.s (2001) survey of 140 venture capitalists from France, the U.K., the U.S. and Canada, not a single analyst used real options valuation. Many factors may account

Indeed, at the time of the survey, Argentinas stock exchange displayed about 30 actively traded stocks only.

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for these low numbers: the sheer inexistence of an option component in the project under appraisal; difficulties in properly modeling the options embedded in real assets; debatable simplifications rooted in the assumption that real and financial options are analogous; and plain computational hassle. These factors may compound in emerging markets, where real option parameters may be more difficult to measure.

Economic Value Added (EVA) is not used as widely as a primary tool by Argentine corporations and advisors, as it is by about 50% of the banks (and insurance companies) surveyed; but it is used by almost one third of corporations and advisors surveyed, as a secondary valuation tool (Item 10). In contrast, EVA is a popular technique among U.S. financial analysts (Block, 1999).

3.2. The cost of capital

3.2.1. Asset pricing model.

With the increasing interest in emerging markets throughout the 1990s, academics and practitioners have developed a number of models to compute the cost of capital in an international setting. In this section, we discuss eleven pricing models (which are summarized in Table 3 for easy review) to move on to report on the models that Argentine appraisers employ in practice.

Put Table 3 about here

3.2.1.1. CAPM-based models.

CAPM-based models are extensions and modifications of the classical single-factor U.S. CAPM. Those believing that world financial markets are deeply integrated propose the use of the Global CAPM (G-CAPM), the most simple extension of the U.S. CAPM to the international finance arena

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(see Table 3). The G-CAPM (also called International CAPM, or I-CAPM) (OBrien, 1999; Stulz, 1995, 1999; Schramm & Wang, 1999) assumes that an investor located anywhere in the world could rapidly enter and leave any market, with reasonable certainty on the final value realized, and incurring in minimum transaction costs. Yet the application of the G-CAPM to emerging markets is controversial, since these markets tend to be segmented from the world capital markets by barriers that decrease efficiency (Bekaert et al., 1997; see also: Harvey, 1995; Bekaert and Harvey, 1997; Solnik, 1996).

When analysts believe the emerging market to be segmented, they may resort instead to the use of a Local CAPM (L-CAPM), whose parameters (riskfree rate, beta and market risk premium) all come from the emerging market itself (see Table 3). In practice, the local markets riskfree rate is the sum of the U.S. riskfree rate and some kind of country risk premiuma complex composite of different country-related risks. Among these we find: social and/or political turmoil which may negatively affect company performance; the chance of expropriation of private assets by the government; the possible emergence of barriers to the free flow of cross-border capital streams (which may restrain, for instance, the remittance of royalties to headquarters); the chance of currency devaluation or revaluation; the chance of sovereign default (the emerging market government not paying its international debts, which may make the country credit rating plunge and the local cost of money soar); and the possibility of unexpected inflation.

One problem with the L-CAPM is that it tends to overestimate the cost of equity. Erb et al. (1995) have shown that market risk does already include a component of macroeconomic risk. In fact, country risk explains on average about 40% of the cross-sectional variation in the volatility of market returns. As such, the inclusion of a country risk premium into the CAPM equation doublecounts country risk, since part of it may be already present into the market risk premium (Godfrey and Espinosa, 1996).

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The Adjusted Local CAPM (AL-CAPM) (Pereiro, 2001a) circumvents the double-counting problem by correcting the market risk term with the (1 - Ri ) factor, where Ri is the coefficient of determination of the regression between the volatility of returns of the local company and the variation of country risk. The (1 - Ri ) factor may be thought of as the amount of variance in the equity volatility of the target company i that is explained by country risk; hence the inclusion of the factor depresses the equity risk premium to somewhat counter the risk overestimation problem of the L-CAPM.
2 2 2

Yet analysts using the L-CAPM or the AL-CAPM need to deal with an additional implementation difficulty: in emerging markets, very high volatility renders the computation of long term market premiums and betas quite complicated, since historical series are highly unstable, and data tend to be unreliable or simply useless. For instance, it is not uncommon to find negative market risk premiums for emerging markets.

The quality problem of the local market data may be alleviated, though, by using hybrid CAPMbased models, whereby global and local data are combined. For instance, Lessard (1996) conceives the U.S. market as a good proxy for the global market, and calibrates the U.S. market premium to the emerging market via a country betathe sensitivity of stock returns in the local economy to U.S. stock returns (see Table 3).

Yet Lessards (1996) model does not account for the problem of risk double-counting. Godfrey and Espinosas (G-E) (1996) model solves the problem by applying a correction factor of (1 0.4)= 0.60, where 0.40 is the average coefficient of determination of the market equity volatility against the country credit quality, as per Erb et al.s (1995) findings. The G-E model implies, however, the strong assumption that it is acceptable to use a constant correction factor instead of the true (and bound to vary with time) coefficient corresponding to a specific pair of markets. The Adjusted Hybrid CAPM (AH-CAPM) (Pereiro, 2001a) circumvents this limitation by using the true coefficient of determination of the regression between the volatility of returns of the local company

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and the variation of country risk, in the very same way the AL-CAPM does. In contrast to the AHCAPM, the Goldman Sachs (G-S) model (Mariscal and Hargis, 1999) uses the correlation between country and market returns to avoid the problem of double-counting risk. The G-S model incorporates also an additional firm-specific risk premium into the pricing equation. The last two CAPM-based models in Table 3 adjust for firm-specific risk as well, but in the country risk term: Damodarans (2002) model uses a single firm-specific coefficient, while the Salomon-SmithBarney (S-S-B) model (Zenner and Akaydin, 2002) features three different exposure coefficients that moderate the country risk premium.

3.2.1.2. Non-CAPM based models. Appraisers dubious about the virtues of tampering with the classical CAPM equation to account for the special features of emerging markets, may resort instead to non-CAPM based modelsvariants that use risk measures other than beta.

The Erb, Harvey and Viskanta (1996) model relies on a non-equity market risk measurethe country credit ratingto obtain the cost of equity (see Table 3). As long as such credit ratings for a country exist, the EHV model allows one to compute the cost of equity even if the country has no operating stock market. Yet Estrada (2000) has argued that the EHV model poses two problems: first, the method estimates a countrywide cost of capital and cannot be used at the company level; and second, the country risk ratings are highly subjective perceptions of risk. Estrada (2000) proposes, in turn, the use of a market-derived downside risk measure that replaces beta. This measure is defined as the ratio between the semi standard deviation of returns with respect to the mean in market i and the semi standard deviation of returns with respect to the mean in the world market. Estrada (2000) argues that his model better fits the risk perceptions of investors, as it renders cost of equity figures that are halfway between the figures obtained with the standard CAPM (normally too small in the view of practitioners), and the larger figures obtained with total risk methods (which may be perceived as way too high by

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practitioners); in this sense, the model would better reflect the partial integration under which many emerging markets operate.

3.2.1.3. What is best practice in multinational asset pricing?

The co-existence of the many models reviewed suggests that academics and practitioners are far from reaching a consensus on what the best asset pricing model is for emerging markets. The issue of what a best model is, is in itself a complex one: academics will probably prefer a statistically powerful design, while practitioners will probably tilt toward easy-to-use models that render plausible or acceptable figures for the cost of equityin the sense that the figures align with the analysts a priori risk perceptions on the project under appraisal.

Choosing a particular asset pricing model is not a trivial decision, since different variants may lead to radically different figures for the cost of capital. Bruner and Chan (2002) estimated the cost of equity of large firms located in Brazil, South Africa, Thailand, Malaysia and Poland via four different models (CAPM, I-CAPM, a Lessard-type (1996) model and a multifactor model), finding in some cases material differences, in the order of 300 to 1,000 bps. Pereiro (2001a) used seven different asset pricing models (G-CAPM, L-CAPM, AL-CAPM, AH-CAPM, G-E, E-H-V and Estradas) to compute the cost of equity of a large Argentine bank, obtaining figures that ranged between 7.5% and 30.8%.
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What do U.S. practitioners use in multinational valuation? Reeb, Kwok and Baek (1998), Pettit et al. (1999) and Stulz (1999) report that U.S. practitioners prefer to use a higher discount rate for evaluating international projects as compared to domestic ones. Graham and Harveys (2001) survey shows that 50.95% of U.S. respondents evaluating a new project in an overseas market

The pricing differential caused by the use of local versus global models may be negligible in developed financial markets that are essentially well integrated (Bruner et al., 2003). For instance, under the assumption of full financial integration, Koedijk et al. (2002) have shown, for a sample of 3,293 stocks from nine developed countries, that the L-CAPM yields a significantly different estimate of the cost of capital from a multifactor G-CAPM for only five percent of the firms in the sample.

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use always or almost always a risk-matched discount rate that incorporates both country and industry effects, while 34.52% of the sample applies a country-specific discount rate. All these studies suggest that the use of idiosyncratic risk premiums is not at all uncommon among practitioners.

3.2.1.4. Asset pricing in Argentina.

Pricing model. Our survey shows that CAPM-based models are the preferred choice in Argentina (Item 11), a behavior in line with U.S. practice (Bruner et al., 1998; Graham and Harvey, 2001). CAPM versions are used by 68% of corporations and 64% of financial advisors. In contrast, Arbitrage Pricing Theory (APT) is not frequently used in Argentina (Item 11). Since APT models allow for the individual and explicit modeling of the typical components of country risk inflation, discriminatory taxation, sovereign, political and exchange riskthey could be thought of as a good replacement to the CAPM in emerging markets. Still the analyst there is confronted with macroeconomic data series that are usually incomplete, extremely short and very volatile, and hence highly unreliable, making the use of APT impractical. In addition, as in the U.S. case, the factors that should be employed within an APT structure are not known; hence model misspecification is always a potential problem. This may help explain the little popularity of APT among U.S. practitioners as well (see Bruner et al., 1998).

Regarding non-CAPM based models, untabulated analysis of our sample shows that only one corporation (multinational and unquoted in the local exchange) uses the Erb-Harvey-Viskanta (1995) model to compute the cost of capitalyet in parallel with a local CAPM version. No respondent reports to be using a downside risk model like Estradas (2000).

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Riskfree rate. The majority (74%) of corporations in our sample are using a U.S. government bond yield for the riskfree rate, and are thus computing U.S. dollar-denominated discount rates (Item 12). This suggests a surprising preeminence of the U.S. dollar as the reference currency in the valuation exercise, regardless of the origin of the company: untabulated analysis shows that 74% of respondents in this group are non-U.S. firms (Argentine or else). The use of U.S.-based discount rates is even more popular among financial analysts and PEFs (Item 12, 82%).

Bruner et al. (1998) show that long-term riskfree rates are the most popular option in the U.S., both among advisors and corporations; matching the terms of the reference bond and the investment project is also a frequent behavior. Item 13 in our survey shows that a majority of Argentine corporations and advisors using U.S. riskfree rates, employ the yield of longer term bonds. Item 14 shows, in turn, that most advisors do apply term matchingbut not most of the corporations.

Country risk premium. Most corporations in our sample (78% of those using U.S. dollardenominated discount rates) use a CAPM version that includes a country risk premium (Item 15). Along the same line, the majority (89%) of advisors also apply a country risk premium. These findings suggest that country-idiosyncratic risk premiums are usually employed by Argentine appraisers.

Most U.S. analysts appraising overseas investment projects compute the country risk premium as the yield spread between a global bond and a sovereign bond of similar maturity from the local market (see e.g., Godfrey and Espinosa, 1996; Lessard, 1996; Budyak and Hackett, 2000). We find that Argentine practitioners behave along the same line: most corporations compute the country risk premium as a sovereign yield spread; of those using a premium, 72% compute it as
5

Emerging market firms that quote debt in a U.S. stock exchange may use their U.S. dollar-based debt yield as a proxy for country risk premium. In our sample, YPF-Repsol is the only company that quotes in the NYSE.

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the yield of a sovereign U.S. dollar-denominated Argentine bond over a U.S. bond; the rest apply a premium but do not specify its source (Item 15). As for advisors and funds, all of them compute the premium as a sovereign bond yield spread.

Betas. If a Hybrid CAPM model is being used, should the appraiser employ a local or a foreign (to the emerging market) beta? A local beta is used in the G-S and Damodarans models (see Table 3). The use of a local beta is, however, difficult to implement in emerging markets, where the data series to compute betas tend to be unacceptably short; the returns, very volatile; and the comparable firms, scarce or simply unavailable.

The alternative approach calls for using a foreign beta, be it a global beta (computed, for instance, against a world market index like the MSCI World), or a U.S. beta (computed, for instance, against the S&P 500 Index). In Table 3, the AH-CAPM and the S-S-B model use a global beta, while Lessards model uses a U.S. beta.

The use of foreign betas is a commendable recipe when there are only a few or no comparable firms in the local market, or when local data is unreliable. Yet it is a problematic procedure if comparable betas are really not stable across borders. Shapiro (2003) has argued that industry betas will likely differ across borders, for local operations are likely to depend on the local economy, thus making the timing and magnitude of returns different from those of the returns produced by foreign comparable companies in the same industry. Along the same line, Damodaran (2002) has argued that betas may be different for the same industry in developed versus emerging markets when products or services are discretionary. Discretionary products those whose purchase can be delayed or deferred by customers in the event of a slump in

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economic activitycommand larger betas than non-discretionary products. For example, phone services may be a discretionary expenditure in an emerging market, but a non-discretionary one in a developed market. The discretionary nature of an industrys offerings may vary across countries, and with it, the industry betas. These arguments notwithstanding, the use of foreign betas in asset pricing is a problem only if betas are in fact significantly different across borders. Whether this is the case or not is a matter not yet adequately settled in the literature.
6

In our Argentina survey, Item 16 suggests that only 32% of corporations use betas derived from comparable U.S. companies. In contrast, the use of U.S. betas is very popular among advisors and funds (64%). Further, many of the respondents using U.S. betas seem to believe in the cross-border stability of betas: only about 27% of corporations, and only 14% of financial advisors use a corrective process when applying U.S. betas to Argentina. Finally, many corporations in our survey (60%) use the same beta for different projects (Item 17); this is clearly a conceptual error unless the appraised projects were tightly related to the core business of the company and have similar debt capacity to the overall company, and so share a similar level of risk.

Market risk premium. A portion of respondents in our survey rely on their own computation of the market risk premium (Item 18). We asked them whether they computed arithmetic or geometric means, in the light of differing opinions among academics concerning the relative benefits of each metric. For instance, Ibbotson Associates (2003) and Copeland et al. (2000) suggest the arithmetic mean should be used, while Damodaran (2002) recommends the geometric mean.

Zenner and Akaydin (2002) found no statistically significant difference between betas of emerging and developed markets, but their analysis was limited to three industries only.

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Our survey uncovers that corporations lean toward the arithmetic average, while advisors and funds share preferences with both the arithmetic and the geometric means. In addition, most firms re-compute their cost of capital figure on a yearly basis (Item 19), as is the case in the U.S. (Bruner et al., 1998).

3.3. The treatment of size and illiquidity effects

The finance literature describes a number of empirical anomalies and suggests that, beyond the systematic risk embodied in the CAPM beta, other factors may have an influence on stock returns and should be priced as well. Among these factors are: the relative or absolute size of the firms market capitalization (Banz, 1981; Chan et al., 1985; Fama and French, 1992); the ratio of price to book value (Fama and French, 1992); the illiquidity (or lack of marketability) of the stock appraised (Mikkelson and Partch, 1985; Pratt et al., 1996; Koeplin et al., 2000; Estabrook, 2000; Damodaran, 2002); the control characteristics of stockholdings, that may reduce or increase firm value (Pratt, 2001; Dyck and Zingales, 2002); the discount on firm value that may take place when a key top manager leaves the target firmthe key-person discount (Bolten and Wang, 1997); the trading volume (Roll, 1981); the momentum (Brennan et al., 1998); and the diversification discount, whereby unfocused, conglomerate-type firms seem to trade at prices below those of focused, undiversified firms (Berger and Ofek, 1995; Lins and Servaes, 2002; Campa and Kedia, 2002).

The existence of these anomalies is still subject to debate as are the possible ways to quantify them. Yet they are difficult to ignore because of their large potential impact on company value. We next review the evidence on two particular effectssize and illiquidityin the U.S. and elsewhere, to move on to report on the treatment of these effects by respondents in our survey.

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3.3.1. The size effect

The size effect was discovered using U.S. stock market data by Banz (1981) over the 1936 1975 period. Banz (1981) showed that, even after adjusting for systematic risk, small quoting firms seemed to have larger returns than large quoting firms. Banzs (1981) findings were the seed of a steady stream of research on the size effect (for a summary of surveys, see Table 4).

Put Table 4 about here

Many studies confirm that the size effect exists and is significant. Chan et al. (1985) confirmed that the effect was present in the U.S. stock market over the 1958-77 period. The work by Fama & French (1992) strongly reinforced Banzs (1981) conclusions and radically attacked the validity of the classical CAPM. The effect was also shown to exist in other developed markets: Chan et al. (1998) found that firm size was an important source of covariation among stock returns for the U.S., the UK and the Japanese equity markets; Beedles (1992) found a significant size-related return differential for the Australian stock market; and Heston et al. (1995) and Arshanapalli et al. (1998) found the effect in large samples of developed markets.

Practitioner-oriented literature has also emphasized the existence of a size effect. Using data from 1926 to 2002, Ibbotson Associates (2003) has broken down NYSE, AMEX and NASDAQ returns into deciles by size, as measured by the aggregate market value of common equity, finding a differential return in the range of 3.7%-9.6% between the first and tenth deciles. A PricewaterhouseCoopers study (Pratt, 2001) extended the analysis by using 25 size groups, seven additional size criteria, and a selection process that screened out companies with poor financial characteristics; this study found a return differential ranging from 6.2% to 11.6%. Finally, other studies have analyzed the value multiples of merger and acquisition (M & A) transactions

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on private companies, finding that smaller companies in most industries tend to sell at lower multiples of most financial variables than larger companies in the same industry. For instance, Pratts (2001) analysis of small U.S. firms found a size-related return differential of 14% to 18.3%; and Mergerstats analysis of middle market transactions in 2000 found an average 11.2% return differential (Pratt, 2001).

Yet another stream of research has questioned the influence of size on company returns. Amihud, Christensen and Mendelson (1992) argued that Fama and Frenchs (1992) U.S. data were too noisy to invalidate the CAPM. Black (1993) suggested that the size effect found by Banz (1981) could simply be a sample period effecti.e., it could be observed in some periods and not in others. Berk (1997) argued that the size effect is the product of using a firms market value of common equity as the size measure, yet other measures of size show no evidence of a relation between size and return. Shumway and Warther (1999) found that the size effect vanishes from NASDAQ data when a correction for delisting bias is made. Garza-Gmez et al. (1998) showed that a size effect was present in the Japanese marketbut with the incorrect sign (i.e., they found a positive relationship between measures of physical size and return). Finally, Bossaerts and Fohlin (2000) did observe the effect in the German market over the period 1881 1913, yet they argued it was likely caused by selection bias.

The evidence on the size effect is also controversial in emerging stock markets. Herrera and Lockwood (1994) found a significant size effect for the Mexican stock market (see Table 4). Using the multiples approach, Pereiro (2001a) found a size-related return differential of 12.8% between small and large firms. Fama and French (1998), Patel (1998) and Rouwenhorst (1999) found a significant size effect in large samples of emerging markets. In contrast, Hart et al. (2001) found no significant size effect in emerging markets. Barry et al. (2002) did find a size effect for thirtyfive emerging markets over the 1985 2000 period, yet the effect lacked robustness to the removal of extreme returns. Barry et al. (2002) found that the significance of the effect was

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dependent on the definition of firm size: significance was high when size was defined relative to the local market average, but nil when absolute firm size was used.

The contradictory evidence reviewed so far attests to the strong and ongoing debate on the existence and importance of the size effect. It should come as no surprise, then, that practitioners may still find themselves in the dark as to whether or not to apply the effect when valuing an investment project. The only survey that reports on the use of corrections for size we know of is Graham and Harvey`s (2001), which finds that 66% of U.S. practitioners do not apply a correction for size when valuing a U.S. investment project. Of the 34% that do, 14.57% adjust for size in the discount rate, 6% in the cashflows, and 13.43% in both.

How do Argentine practitioners react on the size matter? Item 20 in Table 2 shows that none of the corporations in our sample apply a discount for size. One reason for this finding may simply be sample bias: all respondents are in fact international firms or well-established domestic groups that can be featured as large firms, at least at the local level. Respondents may thus perceive their firms too large as to be vulnerable to the deleterious effect of smallness. Concerning financial advisors and PEFs, we can only speculate on the size of the firms they appraise; yet 36% of these respondents do apply an unspecified correction for size.
7

3.3.2. The illiquidity effect

The shares of a quoting (public) firm are more liquid than those of a non-quoting (private) firm, since they can be rapidly and easily traded in the stock market, with considerable certainty on the realization value, and with minimum transaction costs. For a non-quoting company, finding a new stock owner is, on the other hand, a difficult process, which may take a long time and can even

7 Indeed, the smallest firms in our sample are, in terms of revenues, larger than the smallest public firms that quote in the local stock market.

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never verify. As a result, the shares of a privately-held company are less marketable, or more illiquidand hence less valuablethan those of a quoting company. This illiquidity translates into a discount on the price at which shares of a private company are sold as compared to the selling price of shares belonging to a quoting but otherwise similar company. Table 5 shows a synthesis of empirical surveys on the discount for illiquidity.

Put Table 5 about here

The first category of surveys in Table 5restricted stockcorresponds to the analysis of differences between prices of ordinary and restricted stock of the same company. Restricted stock is identical to common stock except that it cannot be publicly sold for a certain time period (normally not exceeding 1 year). On average, this survey category shows that the median illiquidity discount is about 33%, a figure close to 35%the magical number that many U.S. practitioners use (Pratt et al, 1996). However, Bajaj et al. (2001) suggest that early restricted stock studies do not take into account factors other than illiquidity that may also be influencing stock prices. Studies that do control for such factors (like Hertzel and Smith, 1993 and Bajaj et al., 2001) report illiquidity discounts in the range of 7.2 - 13.5%about a third of the figure suggested by early studies.

However, restricted stock is not a perfect equivalent of ordinary stock, since it will eventually profit from the benefit of trading in the public market; ordinary private company shares will then be necessarily more illiquidi.e., be worth less thanletter stock. Evidence for this argument can be gathered in the second category of studies in Table 5the IPO approachthat shows illiquidity discounts on shares before and after an initial public offering. As expected, the average discount is larger in this survey category, with a median close to 50%, reflecting the fact that the shares of a private company do not bear the benefit of having an assured public market when ready to be traded. Bajaj et al. (2001) have argued, however, that the IPO approach seriously

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overstates the illiquidity discount, for two reasons: first, pre-IPO transactions may occur at lower prices since investors may be being compensated for providing specific services (like when venture capitalists provide monitoring and advice to a closely held firm); and second, only firms that are ex post successful will conduct an IPO, then the IPO price will appear high relative to the price of pre-IPO transactions.

The third and last category of studies in Table 5 reports the illiquidity discount based on acquisition multiples of controlling interests of public versus private companies. In the U.S., Mergerstats 1994 study compared the P / E ratio of public versus private companies, finding an average illiquidity discount on the value of equity of 27.5% (Pratt et al., 1996). Koeplin et al. (2000), in turn, compared the ratio of market value of invested capital (MVIC) to EBITDA for 84 U.S. transactions, getting a discount of about 18%-20%. Our third survey category suggests, then, a U.S. median illiquidity discount of around 24%. These figure should probably be considered as an upper bound on the discount, as the studies in the category do not fully control for stock features other than illiquidity.

For non-U.S. markets, Koeplin et al. (2000) analyzed the MVIC/EBITDA-based discounts for 108 non-U.S. transactions, arriving at a 23%-54% discount range. Koeplin et al. (2000) speculate that the lower liquidity of developing financial markets and the relatively less access to capital for private firms in these settings may explain the relatively large private company discount that was found. Finally, Pereiro (2001a) analyzed P / E acquisition multiples for 91 transactions in Argentina, finding an average illiquidity discount of about 35%. Summarizing, then, there is agreement on the financial literature on the existence of an illiquidity-related discount on the value of a firms shares, though the amount of the discount varies widely among studies.

How do practitioners treat illiquidity effects in Argentina? Item 20 on Table 2 shows that only one out of 16 closely-held respondents (or 6% of our sample) applies a correction for illiquidity.

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Regarding financial analysts and funds, we can only speculate about the illiquidity features of the firms they appraise; yet users of illiquidity discounts in this sub-sample amount to 36%a much larger figure than that for corporations.

The disregard for illiquidity among closely held corporations in our sample is surprising, as these firms are prone to suffer a discount on their stock price if put to sale in the private market. A plausible explanation for this behavior may be rooted in the private benefits of control. In countries with poor minority investor protection, controlling shareholders have more fear of being expropriated themselves in the event that they ever lose control through a takeover or a market accumulation of shares by a raider, and so might be unwilling to cut their ownership of voting rights by selling shares to raise funds or to diversify (La Porta et al., 1999). Poor investor protection increases the liquidity costs associated with asymmetric information (Brockman and Chung, 2003) and enlarges the private benefits of control.

Legislation in Argentina provides, indeed, limited protection to minority investors (Pereiro, 2001b).
8

Then the controlling shareholders of closely-held firms in this market may be

commanding very high control premiums that more than compensate for the illiquidity discount produced by not being quoted in the capital market. In other words, control benefits may explain why owners of private Argentine firms are reluctant to securitize them even if substantial liquidity value would be added by so doing. This need for control may help explain the retrogressive path of the Argentine stock exchange, in which the number of quoting firms has been consistently decreasing from 1988 to 1998, with a total fall of about 31%, in spite of the liberalization and concomitant growth experienced by the economy along the 1990s.
9

La Porta et al. (1999) classify Argentina as a country with relatively good formal (legal) investor protection, together with Australia, Canada, Hong Kong, Ireland, Japan, New Zealand, Norway, Singapore, Spain, and the U.S. Yet corruption may hamper the efficiency of the legal system. Argentina is the country with less transparency in the group (Corruption Perceptions Index [CPI]= 2.8, as per Transparency International, 2002), far from the next less transparent country in the group, Ireland (CPI= 6.9). It is suggestive that La Porta et al (1999) find Argentina to be the only country in the above group in which the purported legal protection has no impact, as there is not a single widely held firm among the 20 largest firms quoting in that market.
9

For a discussion on the relationship between the protection of minority investors and the development of security markets, see Modigliani and Perotti (1997).

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Can control benefits in Argentina outweigh the illiquidity discount? Control premiums for this market have been found to range from 12% (Dyck and Zingales, 2002) to 38.7% (Pereiro, 2001a). These figures translate into a minority discount that ranges between 11% and 28%not fully compensating for the 35% illiquidity discount reported earlier, but still providing some rationale for the infrequent use of illiquidity discounts in our sample.

4. Concluding remarks

In this article, we describe the valuation practices used in Argentina, showing that there is considerable alignment with U.S. practices. First, our survey uncovers that valuation techniques like NPV, IRR and payback are very popular among corporations and advisors. Second, CAPMbased models are a popular choice. Third, the CAPM is frequently modified with the addition of a country risk premium. In particular, and in line with U.S. practice, MNCs seem to be applying material country risk premiums to account for a potentially catastrophic segmentation of the target market.
10

Fourth, surprisingly, capital budgeting analyses are performed in U.S. Dollars by many

non-Dollar companies. Fifth, financial advisors apply U.S. betas to the emerging market, yet they rarely correct betas for cross-border asymmetries. Last, corporations tend to disregard firmspecific risks like those driven by small size and illiquidity.

We believe the popularity of the CAPM in our sample is not surprising for at least three reasons: (a) practitioners conceptually rely on the CAPM probably because it is the best-known pricing

Catastrophic segmentation did indeed occur in Argentina. After a decade of openness and currency stability, in early 2002 the currency was officially devalued by 40% and strict foreign exchange and currency controls were established. In just a few days, the country went back to a regulated, fully segmented market (Pereiro, 2002b). Our survey was carried in August 2000, i.e., before the crisis.

10

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model in corporate finance; (b) the models popularity has made it a standard benchmark, and ignoring so will put an analyst at disadvantage, since his or her counterpart in an M & A deal other investors, managers, venture capitalists, angel investors and financial analystsare most likely using also the CAPM as a primary pricing tool; and (c) abundant data already exist for easily applying the model.

Finally, we suggest that the relatively large size of respondents may be responsible for the disregard of the size effect we find in Argentina. Concerning the observed disregard for illiquidity, we suggest it could be rooted in the counterbalance provided by the private benefits of control, which may be substantial in Argentina, a market with poor minority investor protection.

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Table 1. a Companies participating in the survey

Corporations Multinational Name / Sector / Country of origin of capital Non-quoting Financial Advisors and Private Equity Funds (PEFs) Banking Insurance and

1. AGA Argentina / Industrial gases / Germany 2. Aguas Argentinas / Utility / France Banks Financial Advisors 3. Allied Domecq Argentina / Beverages / U.K. 4. Alto Palermo / Real Estate / Argentina 1. Banco de 1. Buenos Aires Capital Ro Negro 5. Autopistas del Sol / Utility / Spain Partners 2. HSBC6. Central Costanera / Utility / Chile 2. Deloitte & Touche 7. Colgate-Palmolive / Cosmetics / U.S. Banco M&A 8. Comsat / Telecommunications / U.S. Roberts 3. Lehman Brothers 9. Danone / Food / France 3. Lloyds 4. Merril-Lynch 10. ECCO / Healthcare / Argentina Bank 5. Warburg Dillon Read 11. Exolgan / Logistics / Argentina 12. Grupo Fortabat / Building Materials / Argentina Insurance Private Equity Funds 13. Molinos / Food / Argentina 1. Alba 14. Nidera / Food / The Netherlands 1. AIG Caucin 15. Oracle / Computers & Software / U.S 2. Argentine Venture 2. LBA-NYL 16. Perdriel / Auto Parts / Japan Partners 3. Mapfre 17. Pernod Ricard / Beverages / France 3. BISA Aconcagua 18. Praxair / Industrial gases / U.S. 4. Global Investment Co. 19. Refractarios Arg. / Building Materials / Arg. 5. Mercinvest 20. Renault / Autos / France 6. Tower Fund 21. RTSA / Telecommunications / Argentina 22. Sideco Americana / Construction / Argentina 23. Siemens-Itron / Electronics / Germany 24. Socoril / Chemicals / Italy 25. Syncro Armstrong / Pharma / Chile 26. Techint / Construction / Italy 27. Telecom / Telecommunications / France 28. TGS / Utility / U.S. 29. Unysis / Computers & Software / U.S. 30. Wella-Ondabel / Cosmetics / Germany 31. YPF-Repsol / Petroleum / Spain Sub-total - # corporations 26 5 7 24 Sub-total - % on sample 84 16 23 77 a Multinational firms are either Argentine firms with substantial international involvement or Argentine subsidiaries of foreign multinational corporations (MNCs). Local firms are those Argentine firms not spatially diversified, i.e., with a primary focus in Argentina. The quoting-non-quoting condition refers to the local (i.e., Argentine) stock market.

Quoting

Local

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Table 2. a General survey results

Corporations

1. Frequency of use of the DCF method

2. If you use DCF, you use...

3. Which of the methods in item 2 is most relevant for you?

4. When using DCF, how do you account for project risk?

5. Do you use a discount rate to account for the cost of capital? 6. How do you compute the terminal value?b

Uses DCF as a primary tool Uses DCF as a secondary tool Primary or secondary depending on the case NA NPV (Net Present Value) IRR (Internal Rate of Return) Payback (Simple) Payback (Discounted) Profitability Index NPV (Net Present Value) IRR (Internal Rate of Return) Payback (Simple) Payback (Discounted) Profitability Index Other NA Cash flow adjustment Rate adjustment Applies sensitivity analysis Applies decision trees Other NA Yes No Perpetuity
With growth Without growth NA

89% 3% 3% 5% 100% 87% 32% 26% 3% 53% 26% 0% 0% 3% 6% 24% 53% 34% 71% 3% 3% 0% 95% 5% 91%
34% 28% 38%

Financial Advisors and Private Equity Funds 73% 27% 0% 0% 100% 73% 18% 18% 0% 83% 33% 0% 0% 0% 0% 0% 45% 64% 73% 0% 9% 0% 100% 0% 82%
45% 9% 36%

Banks & Insurance

50% 17% 0% 33% 100% 67% 17% 0% 0% 64% 36% 9% 9% 0% 0% 18% 83% 0% 50% 0% 0% 0% 100% 0% 60%
20% 0% 40%

7. Frequency of use of the multiples method

8. Use of U.S. multiples and cross-border corrections 9. Frequency of use of the real options method

Cash flow in last period multiplied by multiple Uses multiples as a primary tool Uses multiples as a secondary tool Does not use multiples NA % using U.S. comparables in local market % of previous using cross-border corrections Uses real options as a primary tool Uses real options as a secondary tool Does not use it NA Uses EVA as a primary tool Uses EVA as a secondary tool Does not use EVA NA Uses CAPM Uses APT Other NA Uses a U.S.-based riskfree rate

25% 5% 50% 34% 11% 39% 33% 3% 11% 79% 8% 11% 29% 32% 29% 68% 8% 24% 8% 74%

73% 45% 55% 0% 0% 91% 64% 0% 27% 36% 36% 0% 27% 45% 27% 64% 0% 9% 27% 82%

40% 0% 67% 17% 17% 83% 20% 0% 0% 50% 50% 50% 17% 17% 17% 67% 0% 17% 17% 83%

10. Frequency of use of the EVA method

11. Frequency of use of CAPM and APTc

12. Use of U.S. Dollardenominated discount rates 13. Instruments used for obtaining U.S. riskfree ratesd

T-bill 90 days T-bonds 3-7 years T-bonds 5-10 years T-bonds 10 years T-bonds 20 years T-bonds 10-30 years T-bonds 30 years 10 years or 90 days; it depends.

0% 13% 5% 29% 5% 5% 13% 0%

9% 9% 0% 9% 0% 9% 27% 9%

0% 17% 33% 17% 0% 0% 17% 0%

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14. Do you match the terms of the riskfree rate and the project? 15. Use of a country risk premium 16. Use of U.S. betas and cross-border corrections 17. Do you use a different beta for each investment, project or company under appraisal? 18. Which type of average do you use when computing market risk premiums? 19. How frequently do you re-estimate your companys cost of capital?

Other NA Yes No NA % using a U.S.-dollar denominated rate % or previous using a country risk premium % of previous using a sovereign yield % using U.S. betas in the local market % of previous applying cross-border corrections Yes No NA Arithmetic mean Geometric mean Other NA Monthly Quarterly Twice a year Yearly Continuously/For each project Rarely NA % applying a discount for size % applying a discount for illiquidity

13% 18% 29% 50% 21% 74% 78% 72% 32% 27% 40% 60% 0% 24% 8% 5% 63% 8% 16% 5% 37% 35% 5% 8% 0%e 6%
e

9% 18% 64% 18% 18% 82% 89% 100% 64% 14% 75% 0% 25% 9% 9% 9% 73% Not asked

17% 17% 17% 67% 17% 83% 100% 60% 0% 0% 50% 25% 25% 50% 17% 0% 33% 17% 0% 0% 67% 67% 0% 0% 0% 17%

20. Use of size and illiquidity adjustments

36% 36%

a b

Totals may add up to more than 100% when respondents choose more than one option. Rounding error may be present. Computed on respondents using terminal value. 10.5% of corporations do not participate in the process of defining the cost of equity computation; headquarters define it instead. d Computed on respondents using U.S. bonds. e Computed on closely-held firms reporting on the use of firm-related unsystematic risk adjustments.
c

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Table 3. Asset Pricing Models in Multinational Investment Valuation

Description Model

CAPM-based models

1. Global CAPM (G-CAPM) OBrien, 1999 Stulz, 1999 Schramm and Wang, 1999

CE = Rf G + B LG . (RMG RfG)
where CE is the cost of equity capital, Rf G the global riskfree rate, RMG the global market return, and B LG the beta of the local target company computed against the global market index. When the target company is non-quoting, the average beta of a group of local quoting comparables may be used.

2. Local CAPM (L-CAPM) (as per the formulation of Pereiro, 2001a)

CE = Rf G + R C + B LL . (RM L Rf L)
where RC is a country risk premium, B LL is the local company beta computed against a local market index, and RM L the return of the local market. The country risk premium RC is usually computed as the spread of dollar-denominated sovereign bonds over global bonds of similar denomination, yield and terme.g., American T-bonds if the U.S. market is considered as the global market proxy.

3. Adjusted Local CAPM (AL-CAPM) Pereiro, 2001a

CE = Rf G+ R C + B LL . (RM L Rf L) . (1 - Ri )
where Ri2 may be thought of as the amount of variance in the equity volatility of the target company i that is explained by country risk.

4. Lessards Model Lessard, 1996

CE = Rf US + R C + BC L,US . B US . (RM US Rf

US)

where Rf US is the U.S. risk free rate, RC is a country risk premium that includes the chance of expropriatory actions, payment difficulties and other risks, BC L,US is the country beta (relative sensitivity of the returns of the local [emerging] stock market to the U.S. market returns), and B US is the beta of a U.S.-based project that is comparable to the offshore project. The country risk premium can be computed as a sovereign bond yield spread against U.S. treasuries, as an OPIC insurance premium, or indirectly derived from political risk ratings.

5. Godfrey-Espinosa (G-E) Model Godfrey and Espinosa, 1996

CE = Rf

US

+ R

+ (L / US) . (RM

US

Rf

US)

. 0.60

where Rf US is the U.S. riskfree rate, L the standard deviation of returns in the local market, US the standard deviation of returns in the U.S. equity market, and RM US is the return of the U.S. stock market index. The correlation of returns between markets is assumed to be constant and equal to 1. The complement to one of the average coefficient of determination of the market equity volatility against the country credit quality (conceptually similar to the [1 - Ri2] factor in the AL-CAPM) is assumed constant and equal to 0.60.

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6. Goldman-Sachs (G-S) Model Mariscal and Hargis, 1999

CE = Rf US + R C + (L / US) . B LL. (RM US Rf

US)]

. (1 R) + RId

where Rf US is the U.S. riskfree rate, RC is a country risk premium, L is the standard deviation of returns in the local market, US is the standard deviation of returns in the U.S. equity market, BLL is the beta of the target local company computed against the local stock market index, R is the correlation of dollar returns between the local stock market and the sovereign bond used to measure country risk, and RId is an idiosyncratic risk premium related to the special features of the target firm (e.g., specific firm credit rating as embodied in its corporate debt spread, industry cyclicality, percentage of revenues coming from the target country, etc).

7. Adjusted Hybrid CAPM (AH-CAPM) Pereiro, 2001a

CE = Rf G + R C + BC LG . [B GG . (RM G Rf G)] . (1 R )
where BC LG is the country beta (i.e., the slope of the regression between the local equity market index and the global market index), BGG is the average unlevered beta of comparable companies quoting in the global market (relevered with the financial structure of the target company), and R2 is the coefficient of determination of the regression between the equity volatility of the local market against the variation in country risk. The R2 can be thought of as the amount of variance in the volatility of the local equity market that is explained by country risk; hence the inclusion of the (1 - R2) factor depresses the equity risk premium to somewhat alleviate the problem of risk double-counting. The U.S. market may be used in the equation as a proxy for the global market. The use of a global beta B GG assumes cross-border stability of betas; if this is a dubious assumption, a local beta may be used instead.

8. Damodarans Model Damodaran, 2002

CE = Rf US + R C . + B LL . (RM US Rf

US)

where 1 is a firm-specific exposure to country risk ranging from zero to one, and B LL is the local company beta computed against a local market index. The exposure factor could be, for instance, the percentage of revenues to the parent firm coming from the local (emerging) market.

9. Salomon Smith Barney (S-S-B) Model Zenner and Akaydin, 2002

CE = Rf G + R C . [(1 + 2 + 3) / 30] + B LG . (RM G Rf G)]

where Rf L is the risk free rate of the home country of the multinational corporation doing the valuation, 1 is a firm-related score from 0 to 10 with a 0 indicating the best access to capital markets, 2 is an industry score from 0 to 10 with a 0 indicating the least susceptibility of the industry to political intervention, 3 is a home country firm score from 0 to 10 with a 0 indicating that the investment at the local level constitutes only a small portion of the firms total assets, and B LG is a global CAPM beta for the industry of the investment, properly relevered for the financial structure of the target. The country risk premium RC is assumed nil for most developed markets.

Non-CAPM-based models

10. Erb-Harvey-Viskanta (E-H-V) Model Erb et al., 1996

CS i,t+1 = 0 + 1 . ln(CCRit)+ i,t+1

where CS is the semiannual return in U.S. dollars for country i, CCR is the country credit rating (available twice a year from Institutional Investor magazine), t is measured in half years, and epsilon is the regression residual. The country credit rating is a proxy for political, exchange, inflation and other typical country risk variables.

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11. Estradas Downside Risk Model Estrada, 2000

CE = Rf US + (RM G Rf G) . RMi
where RMi is a risk measure and i indexes markets. RMi is a downside risk measure, the ratio between the semi standard deviation of returns with respect to the mean in market i and the semi standard deviation of returns with respect to the mean in the world market.

Table 4. Empirical Evidence on the Size Effect in Developed and Emerging Markets
Survey Developed Markets Banz (1981) Chan, Chen and Hsieh (1985) Fama & French (1992) Chan et al. (1998) Beedles (1992) Heston et al. (1998) Arshanapalli et al. (1998) Ibbotson Associates (2003) PricewaterhouseCooopers (Pratt, 2001) Pratt (2001) Mergerstat 2000 (Pratt, 2001) Amihud et al. (1992) Black (1993) Berk (1997) Shumway and Warther (1999) Bossaerts and Fohlin (2000) Garza-Gmez et al. (1998) Emerging Markets Herrera and Lockwood (1994) Pereiro (2001a) Fama and French (1998), Patel (1998) Rouwenhorst (1999) Hart et al. (2001) Barry et al. (2002)
a

Market

Period of analysis 1936 1975 1958 1977 1963 1990 1968 1993 1974 1987 1978 1990 1975 1995 1926 2002 1963 1996 1998 2000 1881 1913 1957 1994 1987 - 1992 1990 - 1999 1987 - 1995 1988 - 1997 1982 - 1997 1985 - 1999 1985 - 2000

Size effecta

Supports effect? Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes No No No No No No Yes Yes Yes Yes Yes No No

NYSE NYSE NYSE, AMEX, NASDAQ U.K., Japan Australia Thirteen developed markets Fourteen developed markets NYSE, AMEX, NASDAQ U.S. U.S. U.S. U.S. U.S. U.S. NASDAQ Germany Japan Mexico Argentina Sixteen emerging markets Twenty two emerging markets Twenty emerging markets Thirty two emerging markets Thirty five emerging markets

4.9% 19.8% 12.0% 7.8% 20.6% - 28.8% 3.7% - 9.6% 6.2% - 11.6% 14.0% - 18.3%b 11.2%b 6.8% 34.8% 12.8%b 14.9% 2.7% 9.1%c 0.5% - 18.2% 29.8%

Average annual return differential between large firm- and small firm-portfolios.

The return differential has been derived from the discount for size reported in the original study, by using an average 4:1 equivalence between discount and return, as suggested by Pereiro (2001a). The original discounts reported were: 55.9 to 73.3% in Pratt (2001); 44.6% in Mergerstat 2000 (Pratt, 2001); and 51.3% in Pereiro (2001a). Annual excess returns over index.

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Table 5. Empirical Evidence on the Illiquidity Effect in U.S. and Non-U.S. Markets
Survey category Survey Period Average discount Average of survey category 28.9% Median of survey category 32.8%

U.S. market Restricted stock

SEC Overall Average (1971) SEC OTC Companies (1971) Gelman (1972) Trout (1977) Moroney (1973) Maher (1976) SRC (Pratt et al., 1996) WMA (Pratt et al., 1996) Silber (1991) FMV (Pratt et al., 1996) Wruck (1989) Chaffee (1993) Option pricing2 years Chaffe (1993) Option pricing 4 years Hertzel and Smith (1993) Johnson (1999)

1966 1969 1966 1969 1968 1970 1968 1972 1969 1973 1978 1982 1981 1984 1981 1988 1979 1992

25.8% 32.6% 33.0% 33.5% 35.6% 35.4% 45.0% 31.2% 33.8% 23.0% 17.6% 28-41% 32-49% 13.5% 20.0% 7.2% 47.0% 51.4% 27.5% 20.4% 23.0% 34.9%

Pre-IPOa transactions Acquisition multiples Non-U.S. markets Acquisition multiples

a

1980 1987 1991 1995 Bajaj et al. (2001) 1990 1995 Emory (1994) 1981 1993 Willamette Management Associates 1975 1992
(Pratt et al., 1996) Mergerstat (Pratt, 2001) Koeplin et al. (2000) Koeplin et al. (2000) Pereiro (2001a)

49.2% 23.95%

49.2% 23.95%

1985 1992 1984 1998 1984 1998 1990 1999

29.0%

29.0%

IPO: initial public offering.