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.

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