Valuing Emerging Market Equities - The Empirical Evidence

Abstract

Though practitioners and academics rely on similar conceptual frameworks when valuing international equities in general and emerging market equities in particular, they emphasize different aspects of the framework. In contrast to academics, practitioners adjust discount rates as opposed to cash flows, and use the US as opposed to the global equity market risk premium. After summarizing the arguments on the academic and practitioner sides, this paper lets the data do the judging and presents evidence that US dollar returns on emerging market equities (American Depository Receipts, ADRs) primarily are a function of returns on the broad US equity market (e.g., the S&P 500) and on the corresponding country’s credit default swap (CDS) spreads. Because CDSs are standardized contracts that are far more liquid than dollar-denominated emerging market bonds, we use them in our empirical work. Analyzing emerging market equities from a different perspective, we also find evidence that international valuation multiples are statistically dependent on CDS spreads and macroeconomic growth rates. As macroeconomic conditions in an economy become more volatile, US dollar returns on a specified foreign equity start becoming more statistically dependent on the specified country’s CDS spreads. Moreover, the US and European-sparked financial crisis of 2007-2010 have caused practitioners to de-emphasize the “market is correct” viewpoint in favor of “the markets may periodically under or over-react” viewpoint. In this light, the paper presents evidence on the warning signals of international under or overvaluation. The logical extension of this view is that asymmetric currency expectations need to be modeled in cash flows.

Keywords: emerging market equities, discount rates, ADRs, credit default swap (CDS), financial crisis, warning signals