Aswath Damodaran on cost of equity in frontier markets

Aswath Damodaran on cost of equity in frontier markets -The Asif Khan BlogAswath Damodaran is one of the foremost experts on asset valuation in the world. He is a Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. He has written some of the most popular books on valuation and corporate finance. He has a widely followed blog called Musings on Markets which I strongly recommend my readers to check out.

I had emailed him with a question about cost of equity calculation problem in frontier economies like Bangladesh yesterday. To my utter surprise he replied to my email within a day and granted me permission to post it in this blog.

Let me first explain what the big deal is about cost of equity calculation in frontier economies. Experts have frequently argued that traditional method of deriving “Cost of equity” can fail significantly in frontier/emerging market. They mention 3 main reasons for that.

1. First, the comparable government security in an emerging market may not exactly be risk free. We have seen many sovereign default in the world already. You can see a comprehensive list here.

2. Secondly, there may be limited/questionable estimate of average stock market return in most emerging or frontier markets

3. It may be impossible or difficult to estimate beta because the historical data or expected future returns relative to predicted average stock market index returns needed to estimate project’s beta does not exist. (This portion quoted from this website

The problem is actually larger in the case of Bangladesh due to a number of factors and I would assume that its the same for many frontier countries. That is exactly why I decided to email him. I am putting the exact email exchange word by word.

Asif Khan

Dear Sir,

I know you get this a lot but I am a huge fan of yours. I have read quite a number of your books and have asked many people to follow your blog. I am personally trying to build an education portal (finance, economics, CFA etc) to promote quality and practical education in Bangladesh. I am getting good response not only from Bangladesh but also from around the world in terms of views and comments.

I think what could help my cause is a small guest post from you as you are a legend on valuation. I also know the perfect question that needs to be addressed and I think you will find it interesting. The question is

How to derive the cost of equity in Bangladesh?

The challenges we face are

1.        Our stock indices (DGEN) were calculated very incorrectly which is why they introduced a new index called DSEX but they never provided the historical data. So we really can’t calculate beta. Also as per your book it is better to use bottom up beta in frontier markets.

2.        We don’t have a treasury yield curve based on market pricing. The yield curve that we have, only reflects the cut off yield at the auction date.

3.        There is almost no appetite for long term bonds in the financial community who have very short term liabilities. So using the 10 year government bond as proxy would be difficult. As an example the 10 year government bond yield is around 12% whereas the inflation rate and the 91 day t-bill are both hovering around 7.5%. So using 12% will show most equities as overvalued.

Would really appreciate it if you could tell us how to derive cost of equity in such circumstances.

Aswath Damodaran

My suggestion is that you create a synthetic risk free rate by adding the expected inflation rate (I will assume that it is 7.50%) to a good estimate of a true real risk free rate (I use the US TIPs rate of 1.5%). That will give you a risk free rate of 9%.

The local stock indices are irrelevant and you can use a bottom up beta across emerging markets.

I still have not figured out what could be a good proxy for the true real risk free rate in Bangladesh. Will keep working on it and if I get a convincing answer I will surely update this post.

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

17 thoughts on “Aswath Damodaran on cost of equity in frontier markets

  1. Dear Asif bhai;
    Nice initiative on your part and the reply by Mr Aswith Damodaron.

    Interestingly for long i have been using the 9% as the risk free rate in a diff way. I consider 9% to be the cost of my fund. Why I do so??

    If i take margin loan on 1:1 basis then for every 200 taka (equity and loan) my debt servicing cost (on the margin loan is 18% approx) that is 18 taka on 200 taka. i consider my equity to have no opportunity cost in the sense that my choice of alternative investments are limited (personally i dont do FDR whether Islamic or other).

    However the above assumption does not consider the devaluation of taka issue, as a global citizen i should be thinking in such way i feel, overall i think considering the effort given a return of at least 25-30% on equity should be minimum for staying invested in BD capital market in long run.

    I know my post deviates from your original discussion but thought it worth sharing to know any fallacies in my own arguments. Thanks a lot.

    Sajid Rahman

  2. loved the effort asif bhai. but i am confused. my question is what if the inflation goes up to double digits? emerging market nations have trouble with inflation. then the “synthetic risk free rate” is useless again. and if local stock indices are irrelevant, then how to calculate market return?

    my point of view is that traditional CAPM doesn’t work in emerging market. we look forward to seeing new valuation methods, developed by young talents like yourself, that work for emerging nations.



    1. Actually the inflation that we should use is not “the current inflation” but rather long term normalized inflation. So we just can’t take the inflation at the peak or bottom and use that. The thing with CAPM is the simplicity is useful. I personally haven’t seen a better solution yet.

  3. good initiative asif. the breakout og 9% rf seems simple and logical to me. I believe many of us think in that way but validation from Mr. Damodaran makes us confident.

      1. Thanks bhaiya, but I’ve always used an Equity Risk Premium of 10.68% (country risk premium of 4.88 and risk premium for mature equity market of 5.8%). Can you please explain why you use an equity risk premium of 6%?

        1. Let me give you the short answer first. At my previous firm my colleagues at New York did a comprehensive study of equity risk premiums all across the world. That is the basis for 6-7% ERP for Bangladesh.

          Now, let me tell you why 10.68% ERP is quite impossible for Bangladesh. Using that will give you a cost of equity of over 20% using which you will not get a single undervalued stock in the entire Dhaka Stock Exchange.

          Can you explain why you are using a country risk premium of 4.88%. That seems way too high to me.

          1. I haven’t taken any finance courses yet, so everything I know about valuation I learned from Aswath Damodaran and his podcasts. In his website, he gives a list of country risk premium based on country ratings by Moody’s. I am providing the link to the updated list (January 2014).


            I used 4.88% from the 2013 data. In the updated list for 2014, he uses a country risk premium of 5.4% for Bangladesh.

            And a country risk premium of 4.88% for Bangladesh also seems very high to me. I initially used it in valuations and not surprisingly, all securities I investigated were overvalued. That’s when I stopped relying too heavily on valuation.

          2. I was sort of guessing that you used Damodaran’s numbers. I find these to be high exaggerated for Bangladesh (and some other countries). For now use 6-7% ERP while doing valuation. I will try to go through the Damodaran stuff and figure out why his numbers are so high.

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