Cases involving cross-border litigation often require the valuation of an asset. Broadly, there are three methods to assess the market value of an asset. One approach is the income approach, which is based on projecting the cash flows of an asset into the future and discounting to the present. The underlying economic principle of an income approach is that the value of an asset is based on the expected net cash flow that the asset will produce, discounted to reflect the time value of money and risk. The second approach is the market approach. This approach often relies on available market prices of comparable assets or businesses that were sold under comparable circumstances. A third valuation approach, which will not be discussed in this article, is the cost approach, a non-market method that considers the accounting concept of book value, replacement cost, or amount invested to calculate value. I use the term “asset” broadly to refer to a specific asset, whether tangible or intangible, all assets of a business, the loss of an opportunity, the impact of specific conduct, etc.
Analyzing risk is a key element of a valuation analysis. In economics and finance, the terms “risk” and “uncertainty” are terms of art and likely have different meanings from those terms when they are used, often interchangeably, in everyday vernacular. Risk is the probability of a certain outcome, such as the probability of getting heads when tossing a coin. In finance, the focus is on the probability of achieving an expected cash flow or profitability. Uncertainty, in contrast, is measured by the size of the deviation from that expectation. If a company assigns a one-third probability to having a good, bad, or average year and expects to earn $100 in profits next year if it is an average year, $105 if it is a good year, and $95 if it is a bad year, there is not a lot of uncertainty. If, on the other hand, the company expects to earn $100 in profits next year if it is an average year, $300 if it is a good year, and a negative $100 if it is a bad year, there is quite a bit of uncertainty, even though the expected earnings are the same in both cases.
In cases of cross-border litigation, risk measures specific to the nation where the asset is located, known as country risk, may need to be considered. This is particularly applicable if an income approach is being used but also must be taken into account if applying a market approach. Country risk can include economic factors such as macroeconomic instability, local supply and demand conditions, political factors, and conflicts.
If using a market approach, the choice of comparable transactions or comparable companies should consider country risk as a criterion for comparability. When applying an income approach, determining the discount rate requires quantifying the cost of equity, and quantifying the cost of equity, in turn, requires an identification and quantification of various risk factors.
Risks are classified as either non-diversifiable (systematic, or market risks) or diversifiable (nonsystematic, or asset-specific risks). Country risk likely includes some risk elements that are diversifiable and others that are non-diversifiable. Economic theory dictates that the market compensates an investor only for risk that is non-diversifiable because diversifiable risk can be eliminated by holding a diversified investment portfolio. Non-diversifiable risks, then, affect only the asset being valued and cannot be reduced or eliminated by holding the asset in a diversified portfolio. When calculating the cost of equity, then, only non-diversifiable risk, including non-diversifiable country risk, should be included.
Risk can be reflected in a valuation analysis by assessing either its impact on the discount rate or its impact on forecasted, or expected, cash flows. Diversifiable country risk should be reflected in the cash flows, not the discount rate. Project-specific country risk is typically diversifiable and therefore should be reflected in the cash flows. The forecasted cash flows that should be used in a valuation analysis are the expected cash flows. In calculating expected cash flows, expected weights are assigned to the various possible outcomes, and the probability-weighted outcomes are summed to arrive at an expected amount. To the extent possible, project-specific country risks should be identified and quantified and the effects on future cash flows should be taken into account.
The non-diversifiable country risk that should be included in the discount rate will typically be limited to the additional market volatility of the country’s markets over those of the country from which the risk-free rate is derived. This is because general market risk will already have been included in the risk-free base rate. In certain cases, country risk has been quantified by including in the discount rate a “country risk premium” equal to the respondent’s sovereign spread. This method, however, assumes that sovereign bond default risk and systematic investment risk are not only correlated but are correctly measured by the same metric: the sovereign bond spread. To the extent that such an approach is used, it should be done citing theoretical or empirical support for the assumption that the sovereign spread is an appropriate metric for non-diversifiable country risk for the asset being valued and that the risk should be accounted for by adjusting the discount rate and not the expected cash flows.
Care must be taken not to double-count elements of risk. For instance, in applying the build-up method, a premium for systematic risk is typically added to a risk-free rate, in addition to other asset-specific premiums that may be nonsystematic. Not only might those nonsystematic premiums already be accounted for in the expected cash flows—applying them as part of the discount rate instead of using them to calculate an expected cash flow is not mathematically equivalent and will likely undervalue an asset.
Country risk raises distinct questions in investor-state cases, in which acts of the respondent state can be a source of risk. As in other damages analysis, damages should be calculated to exclude the impact of the specific unlawful act alleged by the claimant. There appears to be no agreement, however, as to whether risks associated with other unlawful state acts should be similarly excluded. If those risks are excluded, a state would be prevented from benefiting from its unlawful actions, which is consistent with a policy objective of facilitating foreign investment, arguably the intent of international investment agreements. If a claimant purchased an investment at a discount due to that very risk, however, the claimant would be overcompensated if damages failed to include that risk element.
Jennifer Vanderhart, Ph.D., is a principal in the Washington, D.C., office of Analytics Research Group, LLC.
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