To determine the intrinsic value of a stock, analysts often use a discounted cash flow (DCF) model to figure out what a company's expected future cash flows are worth to equity holders in today's money. The DCF model forces the analyst to make various assumptions, which is why you'll often see differing opinions of a stock's intrinsic value, depending on which report you read.
The most critical assumption of the DCF process is which discount rate to use when calculating the present value of cash flows. Without getting into mathematical details, the discount rate represents the investor's compensation for the time value of money, adjusting for the risk taken.
Adjusting your discount rate for risk is a very subjective process, and it gets even more complicated when you invest overseas.
Pass the Pepto
Using a simple example, let's say you make a $1,000 investment in two identical companies. One is headquartered in an emerging market, and the other in a more developed market. Based on your calculations, both companies will equally return 12% on your investment, which sounds great -- but the returns aren't truly equal in terms of risk.
If economic and political conditions in the emerging-market company's home country are so adverse that you require a 15% return to adequately compensate you for the risk you're taking, then it's a poor investment decision, regardless of the expected positive return. Conversely, if the developed-market company's economy and politics are favorable, you might only require a 10% return to be rewarded for the risk of investing there, thus making it a better investment decision.
To help you decide which stocks may need a risk adjustment when valuing foreign-based companies, we'll take a closer look at The Economist's recent survey of the global business environment, in which it ranks the "best place[s] to conduct business over the next five years," using metrics such as "macroeconomic stability, infrastructure and policy toward private enterprise."
The envelope, please ...
Here are the top four countries for doing business over the next five years:
|
Country |
Notable Stocks |
|---|---|
|
Denmark |
TORM |
|
Finland |
Nokia |
|
Singapore |
Flextronics |
|
Canada |
Research In Motion |
For those of you wondering, the U.S. placed 10th in the survey.
Give it up for the Danes!
To be honest, I was a bit surprised to see welfare-state Denmark at the top of this list, but that may have been due to my own ignorance. After all, there are only a handful of Danish stocks trading here as American depositary receipts, so keeping track of the Danish economic environment isn't exactly at the top of my to-do list.
Even though the land of LEGO's economy isn't growing at a scorching pace, it certainly appears to be stable and productive. According to The Economist, Denmark's "flexible labour market and highly educated workforce are particularly attractive to businesses." Moreover, according to the magazine's estimates, Danish inflation should remain in the 2% range, along with a positive current account balance, at least through 2012. Finally, unemployment sits at a minuscule 2%, its lowest level since the early 1970s. And despite a slowing economy, Danish businesses are clamoring for skilled employees, particularly in the IT industry.
So while Danish stocks may not be exploding in terms of absolute potential returns, they might deserve a second look for more risk-averse foreign investors. Unfortunately, getting your hands on them as a U.S. investor is a bit tricky. You can read more about TORM and Novo Nordisk, the only two Danish-headquartered stocks trading on a major U.S. exchange, on Motley Fool CAPS.
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