# Erp comparison of developed and emerging markets

My not-so-profound thoughts about valuation, corporate finance and the news of the day! Monday, July 29, 2013 Developed versus Emerging Markets: In my last postI looked at country risk first from both a bondholder perspective with ratings, default spreads and CDS spreads as well as an equity investor perspective with my estimates of equity risk premiums by country. While default spreads in sovereign bonds and differences in CDS spreads are explicit and visible to investors, the question of whether equity markets price in differences in equity risk premiums is debatable.

In fact, there are quite a few analysts and academics who argue that country risk is diversifiable to global investors and hence should not be priced into stocks, though that argument has been undercut by the increasing correlation across equity markets.

- Explore the emerging saas erp market by paul d hamerman, november 11, 2013 updated;
- Monday, July 29, 2013 Developed versus Emerging Markets;
- While it is clear that emerging markets have evolved in terms of economic growth, political maturity and risk, it also remains true that there is more risk in these markets than in developed ones;
- Decline in profitability at developed market companies, relative to emerging market companies;
- Markets can still over shoot:

In this post, I look at the pricing of stocks across different markets to see if there is evidence of differences in country risk, and if so, whether market views of risk have changed over time.

Stock Prices and Risk Premiums Holding all else constant, stocks that are perceived as riskier should sell for lower prices. That can be illustrated fairly simply using a basic discounted cash flow model. Consider a firm that pays out what it can afford to in dividends and is in stable growth growing at a rate less than or equal to the economy forever.

The value of equity in the firm can be written as: Rewriting the expected dividends next period as the product of the payout ratio and expected earnings, we get: Now, assume that you are valuing two companies with equivalent growth rates and payout ratios, in US dollars, and that the only difference is that one company is in a developed market and the other is in an emerging market.

If investors in the emerging market are demanding a higher equity risk premium, the emerging market company should trade at a lower PE ratio than the developed market company. A simple test perhaps even simplistic, since holding growth and payout constant is tough to do of whether equity risk premiums vary between developed and emerging markets is to compare the multiples at which companies in these markets trade. The Pricing Story To examine how developed market and emerging market PE ratios have evolved over time, I computed PE ratios for each company in every market each year from 2004 to 2012, with an update to June 2013.

- Some have kicked off a new round of mergers and acquisitions to turbo-charge their sales, while others have focused their attention on new and untapped opportunities in oft-overlooked verticals or emerging countries whatever the case, the erp market, which has experienced a brutal recession and now;
- If you assume higher growth in emerging markets than developed markets, the table above overstates the equity risk premium for developed markets, while understating the premium for emerging markets;
- In fact, at the 0;
- It is possible that shifts in global economic power have made developed market companies less profitable than they used to be, thus lowering pricing multiples for these companies.

I eliminated any company that had negative earnings and divided the market capitalization at the end of each year by the net income in that year. I then categorized the companies into developed and emerging markets, using conventional geographical but perhaps controversial criteria. In sum, there were 36,067 companies in the developed market group and 24,429 companies in the emerging market group. I considered various summary statistics the simple average, a weighted average, an aggregate market cap to earnings but decided to use the median PE as the best indicator of the typically priced stock in each market.

In the figure below, you can see the median PE ratios for developed and emerging market companies by year, from 2004 through June 2013. In the years since, emerging market companies have clawed their way back and the PE ratio for emerging market companies exceeded that of developed market companies in 2012. The shift away from emerging markets in the first six months of 2013 has put developed companies into the lead again, though the developed market PE premium over emerging markets in June 2013 is significantly lower than the premiums commanded in the early part of last decade.

Deconstructing the Convergence The convergence of PE ratios across the globe is striking, but it is worth noting that it is more attributable to a decline in PE ratios in developed market PE ratios than to a surge in emerging market PE ratios.

In fact, this phenomenon is made more erp comparison of developed and emerging markets if we look at the median price to book ratios across developed and emerging market companies from 2004 to 2013: The convergence that we see in PE ratios is even more striking when it comes to price to book ratios, but note that the convergence is largely coming from the drop in price to book ratios in developed markets, not from a increase in those ratios of emerging markets. The question therefore becomes not whether there is erp comparison of developed and emerging markets, but why the convergence is occurring.

There are at least three possible stories and perhaps more. Decline in profitability at developed market companies, relative to emerging market companies: It is possible that shifts in global economic power have made developed market companies less profitable than they used to be, thus lowering pricing multiples for these companies.

The median returns on equity for developed market and emerging market companies, each year from 2004 to 2013, are contrasted below: Note that emerging market companies have had higher returns on equity than developed market companies in every year.

Declining differential equity risk premium between developed and emerging market companies: A second potential explanation is that the differential equity risk premium between developed and emerging markets has decreased over the last few years.

## Erp comparison of developed and emerging markets

There is a fairly simple mechanism for backing out the implied costs of equity and equity risk erp comparison of developed and emerging markets from the price to book ratios and returns on equity. If we assume firms are collectively in stable growth, the price to book ratio can be written as: Moving the terms around allows us to restate the equation in terms of cost of equity: To compute the costs of equity in US dollar terms, we will set the expected growth rate for each year to be equal to the US treasury bond rate in that year and derive the cost of equity for developed and emerging markets in that year.

I know that assuming the same growth rate in developed and emerging markets is simplistic, but I will revisit this assumption later. For instance, take 2004, when the price to book ratio for developed markets was 2. Bond rate was 4. The implied cost of equity for developed markets in 2004 is 7.

The last column is striking, as the differential ERP dropped close to zero at the end of 2012 before rebounding a little bit in the middle of 2013. In fact, at the 0. Decline in differential real growth: Now, let's revisit the assumption that I made in the last section that both developed and emerging markets will grow at the same rate set equal to the US treasury bond rate each year.

You can take issue with that assumption, since emerging markets have not only more growth potential but have delivered more real growth that developed markets over the last two decades. If you assume higher growth in emerging markets than developed markets, the table above overstates the equity risk premium for developed markets, while understating the premium for emerging markets. I redid the table setting the growth rate in developed markets at 0.

While the differential ERP is higher in every year, with the assumption of higher growth in emerging markets, the trend line remains unchanged with the differential value hitting a low at the end of 2012.

In summary, the shrinking differences in pricing between developed and emerging markets cannot be explained by profitability trends or changes in real growth but can be at least partially explained by narrowing risk differentials between the markets and the globalization of companies. Reality check for expectations in emerging markets: For the last two decades, developed market investors have been lured into investing in emerging markets by the promise of higher returns in those markets, though accompanied with the caveat of higher risk.

If the last few years are any indication, it is time for investors to adjust expectations for emerging market returns, going forward. Emerging market companies are no longer being priced to generate premium returns, but they are also no longer as risky as they once were at least relative to developed market companies.

Markets can still over shoot: While it is clear that emerging markets have evolved in terms of economic growth, political maturity and risk, it also remains true that there is more risk in these markets than in developed ones.

Markets, however, often move in ebbs and flows, under estimating this differential risk in some periods and over estimating it in others. Thus, a reasonable case can be made that markets were being over optimistic about emerging market risks, when they priced stocks to generate roughly the same expected returns in developed and emerging markets at the end of 2012 see the table in the last section and that the correction this year is a reversal back to a more reasonable differential premium.

For those who believe that the reasonable premium is that observed between 2004 and 2006 when the average differential in ERP was 2. If you believe, as I do, that the norm is closer to that reflected in the average since 2008 about 1 to 1. Think global, not local: As companies, notwithstanding where they are incorporated, increasingly become global competitors, it can be argued that equity risk premiums will converge across markets, since each market will be composed primarily of global companies exposed to risks around the world.

For investors and analysts in developed markets, there is the unsettling reality that emerging market risk is now seeping into their portfolios, even if it is composed purely of domestic companies. For investors and analysts in emerging markets, there has to be the recognition that erp comparison of developed and emerging markets automatic discounts that they apply to emerging market company multiples, relative to developed markets, may no longer be appropriate.

I will return to this issue in a future post.