The situation is familiar in valuation, particularly in emerging markets.
You need to value a company, but there are no genuinely comparable listed companies in the local market. The textbook solution appears relatively straightforward: look for comparable companies or transactions in other markets, extract the relevant multiples, and adjust them for differences between the comparable market and the country in which the target operates.
In theory, this is a logical approach. In practice, each step introduces another layer of judgment and uncertainty.
First, you need a reliable comparable.
Sometimes suitable public companies simply do not exist. Private transactions may provide an alternative, but the available information can be limited or outdated. And even when the investment amount and ownership acquired are known, important economic terms of the transaction may remain confidential.
Then comes the adjustment itself.
If a comparable operates in a developed economy and the target operates in an emerging market, it seems reasonable to adjust for differences in country risk, inflation, economic growth and other macroeconomic factors.
But what exactly should that adjustment be?
Estimating it may require assumptions about future inflation, economic growth, risk and other variables that are themselves highly uncertain. Instead of reducing uncertainty, we may simply be adding another layer of it.
One proposed alternative is to compare average market multiples between the two countries and use the difference as a basis for adjustment.
At first glance, this looks more objective.
But are the two markets themselves comparable?
A stock market heavily weighted towards oil, gas, banks or traditional industries cannot necessarily be compared directly with one dominated by technology and other high-growth businesses. Differences in market composition, industry structure and the characteristics of listed companies can materially affect the observed multiples.
And there is another complication.
The emerging-market company itself may have characteristics its developed-market comparable does not: higher market share, less competition, lower customer acquisition costs, higher margins or different growth potential.
If we adjust the multiple downward for macroeconomic disadvantages, should we also adjust it upward for these company- and market-specific advantages?
And if so, how?
At some point, we may take an imperfect but observable multiple and layer so many uncertain adjustments on top of it that the apparent sophistication creates more confidence than the underlying information justifies.
An adjustment is not automatically an improvement.
This does not mean that multiples should never be adjusted. It means that before making an adjustment, we should ask whether we have enough reliable information to believe that the adjustment actually improves the valuation.
Sometimes, acknowledging the limitations of an imperfect comparable may be more defensible than turning it into a supposedly precise number through a series of assumptions that are even harder to observe.