If your views on investing and valuation were formed by reading Ben Graham, and nurtured by listening to Warren Buffett, it is worth remembering the time and the setting for their sage advice. Put simply, the rostrum that when investing in a company, you should focus on the company’s management and moats, and pay little or no heed to governments or macroeconomic indicators, may have worked for value investors in the United States, in the \(1980s\), but will not hold up not just in other parts of the world, but even in the United States in the \(2020s\)1. Globalization and the emergence of a world economy that is no longer centered on the United States has made it an imperative for all investors to think about and understand country risk.

The price of country risk changes on a day-to-day basis based on a variety of variables, including uncertainty around future economic growth, political stability, worries about catastrophes/disasters, investor risk aversion, and information availability/reliability. While it is easy to understand why risk varies across countries, it is more difficult to measure that risk, and even more so, to convert those risk differences into risk premiums. Ratings agencies like Moody’s and S&P provide a measure of the default risk in countries with sovereign ratings, and we build on those ratings to estimate country and equity risk premiums, by country.

The resulting country and equity risk premiums, including sovereign ratings and default spreads, are shown in the table below:

The risk of investing in equities and bonds varies across the world, resulting in higher risk premiums in some markets than others. To estimate the equity risk premiums, a pre-requisite for estimating the values of companies with operations in those countries, we follow a four-step process.

Here we start with the implied equity risk premiums that we estimated for the United States and add it to the risk premium for each country. Note that the country risk in valuation is built on the presumption that a company’s risk exposure is based on where it does business, not where it is incorporated or headquartered. As an example, let’s assume that we want to estimate the equity risk premium for operating in the Dominican Republic.

  1. We start with the implied equity risk premium for the S&P in January 01, 2025, which we estimated to be 4.33%. We use this estimate as the mature market premium.

  2. As a second step, we look up the local currency sovereign rating for the Dominican Republic from Moody’s Sovereign & Supranational and arrive at a Ba3 rating; the typical default spread for a Ba3 rated country on January 01, 2025 was 3.56%.

  1. In the third step, we try to estimate how much riskier equities are than government bonds in emerging markets by using proxies for each one: the S&P Emerging BMI Index (an index of emerging market equities) for stocks, and the iShares JP Morgan USD Emerging Markets Bond ETF (proxy for returns on emerging market sovereign bonds). The ratio of the standard deviation in the former and the coefficient of variation in the latter is 1.35. Multiplying this ratio by the default spread in step 2 yields a country risk premium for the Dominican Republic of 4.8%.

  2. In the fourth step, we add the country risk premium to the implied premium of 4.33% that we estimated in step 1 to arrive at an equity risk premium for the Dominican Republic of 9.13%.

For the interested reader, we suggest looking into this paper by Professor Aswath Damodaran: Country Risk: Determinants, Measures and Implications.

  1. Value Investing in a New World Order↩︎