In an ideal situation, all cash inflows and outflows would be denominated in the same currency. However, in our present-day interconnected world, this is rarely the case.
As a specialist in the valuation of shares, businesses, projects and intangible assets, I am often asked about the correct approach to adopt when dealing with multiple currencies in a discounted cash flow (DCF). A DCF is a valuation method used to estimate the attractiveness of an investment opportunity.
The first element to determine is the currency in which the majority of cash flows are based. There will typically be a currency that dominates.
For example, for a business that earns revenues in US dollars (USD) and incurs expenses in a combination of USD and local currency, it could be deemed that USD is the prevailing currency.
In this case, the generally accepted approach is to perform the valuation in USD; by converting any non-USD cash flows into USD (using an appropriate forward exchange curve) and discounting the cash flows to present value using a USD denominated discount rate.
If the value is required in another denomination, the best approach is to then convert the resultant net present value (in USD in the example above) to the required currency using the spot rate at the date of the valuation. This is often required for financial reporting requirements (however, we note that further specific considerations should be made when determining a valuation for financial reporting requirements). As a valuer, it’s important to be mindful that different valuation purposes may have different approaches.
In some instances, cash flow projections (or DCF models) exist where cash flows have already been converted into a particular currency. In this situation, it is best to convert the cash flows back (i.e. “unwind” the approach initially utilized to convert the cash flows) and then convert the cash flows into the required currency yourself (where required). It is important that this step is undertaken, as relying on the conversions of others can sometimes cause issues, due to the disparity between the discount rate and cash flows. Also, in many instances, the conversion would have been made using the spot rate on a particular date, and often bears no correlation to the rate prevailing on the valuation date.
Currency conversions can have a significant impact on valuation outcomes and should be carefully considered. It is important that there is consistency between the cash flows and the discount rate and that all model inputs are sourced at the relevant valuation date.
There are a number of other potential issues relating to the construction of the discount rate, particularly when dealing with developing jurisdictions and capturing the risk related to local (non-dominant) currency cash flows. This is why it is important to seek proper advice around these calculations and rates.
At Crowe Horwath, we are here to assist with your valuation requirements and look forward to being of service. For more information or assistance with DCFs please contact your corporate finance adviser.
By Nicole Vignaroli
Partner- Corporate Finance