The Beta Dilemma in Emerging Markets

In principle, emerging markets analysts employ the same analytical framework when estimating the value of businesses as their counterparts in developed economies: they forecast future cash flows and discount those to the present with appropriate costs of capital that are estimated using the Capital Asset Pricing Model (CAPM) framework. But in practice, emerging market analysts have a more complicated job because the task of estimating costs of equity in emerging markets is more difficult. Whereas developed economies have an abundance of historical data on overall stock market movements, industry share price behavior, and many individual share price histories, emerging market economies often do not. There may be no comparable local firms that are publicly traded—or if there are, their CAPM betas may be unreliable. And if analysts instead use the beta of a U.S. competitor as a surrogate for the emerging market beta, they face the question of whether domestic betas are equivalent across borders. As a consequence, appraisers of emerging market companies confront a “beta dilemma.” Part of this is a data problem stemming from shorter share price histories in emerging markets and the absence of publicly traded companies in some industries. In such cases, analysts may be inclined to use industry betas calculated with U.S. share prices as a substitute. But this creates an equivalence problem—the possibility, as confirmed by the author's research, that domestic U.S. and emerging market betas are not statistically equivalent for most industries. The author proposes a solution to this problem that involves grouping emerging markets into a single, distinctive asset class that allows for reliable calculations of industry betas. He also suggests ways of testing emerging market industry betas to determine whether they are statistically comparable.