What are country risks?

When companies operate internationally, they face a variety of risks with every foreign investment. These go far beyond the usual entrepreneurial challenges.

Country risks are based on the specific political, economic and social conditions of a country. They can differ considerably from those of the domestic market.

The factors influencing them include geopolitical tensions, political instability, exchange rate fluctuations, unpredictable interest rate developments and high inflation rates. Taken as a whole, they can have a significant impact on a company's business environment abroad.

Moreover, foreign investments often entail risks such as

• Tax uncertainties: Changes in tax legislation or inconsistent interpretations can lead to considerable financial burdens.
• Legal and regulatory risks: Different legal systems and constantly changing regulations make it difficult to comply with legal requirements.
• Business and credit defaults: The creditworthiness of business partners abroad can be impaired due to economic or political crises.
• Legal disputes: Cultural differences, language barriers and complex legal systems increase the risk of legal disputes.

These risks can lead to considerable financial losses. They are also likely to impair the competitiveness of companies. A thorough analysis and assessment of country risks is therefore essential before any foreign investment.

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How country risks can be taken into account in the business valuation

Country risks pose a challenge for business valuation. This is because they make it difficult to determine the future cash flows of a company. Two basic approaches make it possible to include these risks in a valuation:

1. Adjustment of cash flows: Theoretically, country risks can be taken into account directly in the forecasts of future cash flows. However, this would require a very detailed and often unrealistic assessment of the probabilities of various risks. In practice, it is difficult to precisely quantify the effects of political unrest, natural disasters or other unforeseeable events.
2. Increasing the cost of capital: It is more common and pragmatic to increase the company's cost of capital. These costs of capital represent the minimum return that investors expect for their invested capital. By adding a country risk premium to the cost of capital, the increased risk of investing in a particular country is taken into account. This premium represents the additional uncertainty associated with the country in question.

There are three reasons for including risks in the cost of capital:

• Simpler: Increasing the cost of capital is a relatively simple approach to taking country risks into account.
• More conservative: Higher costs of capital make the valuation more conservative, as the future cash flows are discounted at a higher interest rate.
• Standard market practice: This approach is widely used in everyday life and is supported by many valuation models.

By including country risks in the cost of capital, the valuation of a company becomes more realistic and comprehensive. In this way, the increased uncertainty of a foreign investment can be taken into account appropriately and a more sound basis for decision-making can be created.

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The country risk premium in the valuation

The Capital Asset Pricing Model (CAPM) serves as the basis for calculating the cost of capital. In an international context, this model is extended to include the additional component of the country risk premium.  

The CAPM states that the expected return on an investment (such as a share) depends on its systematic risk, measured by the beta factor. In the case of international investments, country risk is an additional factor. To take this additional risk into account, a country risk premium is added to the risk-free interest rate and the equity risk premium.

The country risk premium is important for several reasons:

• Investors demand a higher return for the higher risk of a foreign investment. The country risk premium reflects this compensation requirement.
• Adding the country risk premium makes the valuation of a company more realistic because it takes the additional risk into account.
• The country risk premium enables a better comparison of companies operating in different countries.

Various methods are available to determine the country risk premium, for example:

• Rating-based approaches: Here, the country rating of a rating agency is used as the basis for determining the premium
• Interest rate differential: The interest rate differential between low-risk government bonds in the home country and those abroad serves as an indicator of the country risk.
• Country risk models: Consideration of a variety of factors such as political stability, economic development and legal framework conditions in order to assess the country risk.

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The country risk premium according to Aswath Damodaran: an overview

Aswath Damodaran is known for his work in the field of business valuation. As Professor of Finance at the New York University Stern School of Business, he is considered one of the leading experts on the valuation of companies and assets.

Damodaran works intensively on the topic of country risk premiums and has developed extensive data and models for calculating these premiums for a large number of countries.

It provides its data and calculations for a large number of countries. Although the frequency of updates depends on various factors, Damodaran carries out regular updates to take account of current developments.

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The country risk premium in valuation practice

Country risks are becoming increasingly important in business valuation, especially for companies in high-risk countries.

International accounting standards such as IFRS even explicitly stipulate that companies must assess the impact of country risks on company value. One prominent example is IAS 36, the standard on impairment testing.

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Conclusion - the country risk premium in the context of business valuation

The country risk premium is an indispensable component of business valuation, especially on the international stage. It reflects the additional risks to which investors are exposed when investing in certain countries. These risks have a significant influence on the attractiveness of an investment.

The level of the country risk premium depends on a number of factors. These include political stability, economic development, the inflation rate, exchange rate risk and the legal framework.

Various models have been developed to quantify these risks. One of the best-known models is the Capital Asset Pricing Model (CAPM), extended by an additional factor for country risk.

The consideration of country risks has practical relevance. This is because international accounting standards such as IFRS stipulate that companies must assess the impact of country risks on the value of the company. This is particularly important for companies in high-risk countries.

Determining the country risk premium is associated with challenges: Future trends in the global economy, such as political uncertainties, trade conflicts and technological changes, can have a significant impact on country risks. It is therefore necessary to continuously adapt the models and calculation methods.

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