Companies typically evaluate the returns expected from new investments against a “hurdle rate” or benchmark. Investments that earn returns in excess of the hurdle rate are expected to create value for shareholders and vice versa. Most companies set hurdle rates based on an analysis of their weighted average cost of capital (WACC). When considering investments outside their home country, they normally increase the hurdle rate to account for the additional perceived risks and volatilities associated with the opportunities.

Our capital markets research shows that in faster growing emerging economies such as Brazil, India and China, investors tend to demand lower returns on capital, not higher. We measured the “required return” by quantifying the median cash-on-cash return on capital delivered by companies valued at an enterprise value that is equal to the gross book value, which we call the Zero NPV (net present value) point. This relationship on average reveals the level of required return set by investors as the minimum required to create value.

Using the above relationship, investors appear to be more satisfied with lower levels of current return than a traditional WACC analysis would suggest. The fast growth in emerging markets seems to augment the perception of future value in the minds of investors relative to more mature, low-growth markets. 

For example, a traditional WACC analysis with country risk adjustments based on sovereign bond credit ratings and other factors for Brazil would have implied a hurdle rate averaging about 18% from 2004 through 2007. Brazil was still recovering from government decisions that created hyperinflation over the prior decade, and rating agencies were cautious and slow to improve their risk assessments.

This is much higher than the required return of 11.7% implied by the Brazilian equity capital markets over this period. Investors, ever forward looking, recognized the improving conditions and were enticed by the rapid expected growth, so they priced it into the market. American companies employing hurdle rates of 18% or higher would have likely rejected many desirable value-creating investments during this period.

This gap between the traditional WACC and the required return has narrowed for Brazil, and late in 2011 the two approaches implied the same 10.5% hurdle rate. Despite this, many companies continue to apply elevated hurdle rates when evaluating investments in Brazil and they make similar mistakes when investing in China, India and other emerging markets as well. These companies are likely to continue under-investing in emerging markets and will forgo the considerable revenue growth and shareholder value that is available from such strong growth markets.

The emerging markets of the world are growing much faster than the developed markets and companies that realize the value of growth will ensure their strategic planning and investment evaluation process are not biased against investing in these countries.

Gregory V. Milano is the co-founder and CEO and Jeffrey L. Routh, who's pictured above right, is senior associate of Fortuna Advisors, a value-based strategic advisory firm.
For more from Fortuna, see The Case for Working Capital.