I am estimating the cost of equity via CAPM for a Chinese company using its over-the-counter equity in the US. Hence, I am estimating the cost of equity from the perspective of the US market. Since the equity ownership of the company’s over-the-counter shares is composed of various American funds and institutions, would it still be reasonable to add a country risk premium to the CAPM model in order to reflect the additional risk associated with investing in a foreign company? Or does the fact that I’m using OTC omit that necessity? Any hints would be greatly appreciated.
CAPM model uses risk-free rate, beta of the stock, and equity risk premium of the chinese market. In which moment do you use OTC quotations? I’m curious. In the case you proceding as I said above, you should add the country risk premium.
Actually, I’m calculating CAPM using the risk-free rate, beta and equity risk premium of the US market. The company (which is Lenovo) publishes its financial statements in USD, so to maintain consistency I’m considering the company’s OTC equity when estimating WACC.
If you are estimating WACC, in my opinion what Harrogath mentioned should be used. If you use US data, you will be highly underestimating cost of equity.
I understand that, but I am performing the valuation from the perspective of a US investor who has the option of purchasing Lenovo OTC shares or not. It wouldn’t be very appropriate to use the Chinese market in this regard. If I was evaluating Lenovo’s value in comparison to its Hong Kong Stock Exchange share price, then yes, I would use the Chinese market.
My main reasoning of why I’m leaning towards a country risk premium is because we are talking about a multinational company who operates in more than 160 countries, and thereby it is indoubtedly exposed to the risk associated with those countries. And as a US investor operating in the US market, one ought to be compensated for such additional risk. Obviously, due to data constraints I am opting towards the CRP of China. Lenovo is a Chinese company after all, the majority of its profit before taxation is generated in China, and it is severely affected by the development of the Chinese economy. That’s my assumption anyway. I don’t think it’s wrong, but I don’t know if it’s right either, if you catch my drift.
WACC reflects the company cost of capital in a marginal basis, if capital structure changes, aslo the wacc.
You can calculate the market value of debt of Lenovo, just see the quotations on bloomberg.
You will use CAPM to calculate the required rate of return on equity of Lenovo, but from the perspective of a US investor. So proceed as I said, find the appropiate risk-free rate (Treasury is ok), find the appropiate beta of the stock today (bloomberg should offer this data using the current capital structure of Lenovo and already adjusted for international operations) and use the chinese market equity return for the market primium. To the final value I would add a country risk.
The problem is that beta is calcultated as Cov(Lonovo return , market return) / variance(market return), so in Lenovo’s beta what market return was used? The world market return? The Chinese market return? It surely needs to be consistent with the market primium, right? You are right on that, Lenovo operates in 160 markets, maybe the world market is the relevant market for calculating equity risk premium. I think we need help on this.
I would use risk-free rate of US Treasury, it is the most close paper to the theorical “risk-free” asset. How bloomberg calculates Lenovo’s beta is a mystery for me, which market returns it uses is the key in order to use the appropiate equity market return (the same that beta uses). If you could research more about this could be nice. Share it if you find something
It really depends on which stock we are referring to. If we are talking about Lenovo’s OTC stock (OTC:LNVGY), then I know for a fact that websites like Bloomberg, Yahoo Finance etc. calculate the cost of equity as:
Risk-free rate based on US treasury
Beta as the slope between Lenovo OTC stock returns and S&P 500 returns
US equity risk premium
However, if we’re talking about Lenovo’s stock in Hong Kong (HKG:0992), then I would assume data from the Chinese market is used instead.
Anyway, this got a bit messy. Let me rephrase the initial question: If I calculated the cost of equity using the first method (OTC), then would it be safe to also add a country risk premium in order to take into account the additional risk associated with investing in a foreign company? This is what I’m mainly concerned about.
I’m really in the doubt, never seen this approach. We would add a country risk premium for a stock that operates practically in the whole world, so it is already highly diversified. Maybe solely a china market risk premium is not much accourate.
No, it isn’t much accurate. I’m only using it as a proxy. It’s just an assumption.
The ideal option would be to add a weighted country risk premium for every country where Lenovo operates. However, due to obvious data constraints, the second best option would be to use one country from each of the four geographical market segments where Lenovo operates. But again, due to data constraints that is not possible, and also one country doesn’t really represent a whole region. So, the third best option and the one that sounds more plausible to me is using the CRP of China, the country with most influence on Lenovo’s results.
This is the apporach I’m taking anyway. Not adding a CRP at all would underestimate the cost of equity, in my opinion.
