Is political risk relevant in companies’ valuation?   We could introduce it in the valuation analysis and try to measure it appropriately.

By Eugenio Micheletti* for staffingamericalatina

When a company analyzes a regional growth by acquisitions, it has to think about the political risk, which means how government, congress and justice decisions affect the company’s performance, costs and profits.

Obviously, each country has its own problems, culture, and idiosyncrasy, but also a government with economic and political philosophy. This is a key issue when making a decision regarding the country to invest, because it has to match with company’s way of doing businesses, and the company’s risk appetite.

Regulations related to dividend transfers, taxes, unions’ behavior, work flexibility, social security costs, assets property treatments, etc., could make a country more attractive than others.

There are many ways to include political risk in the valuation analysis, and each of them has its’ own characteristics, so the procedure is risky by itself.

If we used the Discounted Cash Flow method, we could add a political risk premium to the discount rate (as portfolio theory suggests). In such case what we have to take care is not to penalize the whole cash flow too much, as the discount rate is applicable to every cash flow, including the Terminal Value, and the political conditions might improve within the following years (with the arrival of a Government with different criteria and policies, the business environment could change).  The actual political situation defines a higher discount rate to be used in every cash flow, but the valuation should consider the political situation in the long term.

The Terminal value represents the continuing value of the company, and mathematically is a cash flow in perpetuity.

Hence, a higher discount rate supposes an important impact in the fair value; in that case we are reducing the company value.

Alternative approaches

In an emerging country, that could have a specific political risk in certain issue related, for example, with regulations or union claims, we could add a premium of risk to the discount rate in some years in our DCF approach, until we predict the political risk will be normalized (it will be diminished, or become zero in a few years, depending on political stability trends). After those years have passed, we may continue by using the WACC (Weighted Average Cost of Capital), including a normal (or null) Political risk estimated.

On one hand, we do not penalize the entire cash flows. On the other hand this procedure could be considered as subjective and difficult to support.

As an alternative approach, we could analyze the impact of the political risk on the target company’s cash flows.  For example, the local government could increase the profit tax rate, limit or increase the timing of VAT returns on capital expenditures or impose price control on your target company’s output. Then, by applying the company’s value sensitivity analysis we would see the importance of those factors in relation to the company’s value.

This procedure is more complex, but provides better measures the share of the risk that affects the valuation. Therefore, this procedure is easier to support technically.

Lastly, we could assume that country risk roughly includes the political risk, and does not add any extra premium risk.

Summarizing, political risk affects the value of the companies in a specific market.  From the buyer’s perspective this is one of the reasons that generates a decrease on the fair value of companies within an adverse political context, creating interesting opportunities for purchase. In addition, political risk has to be analyzed deeply to avoid under or overestimation, in order to achieve a fair value.

*Eugenio Micheletti is Director of Emerging Staffing Brokers

emicheletti@emergingsb.com