Brexit – FX and cost of capital
In this Insight we look at the FX moves triggered by the Brexit referendum decision, and how best to communicate the impact to investors, using ARM as a case study. This is not just about revenue mix. The press got very confused comparing stock market declines across Europe, forgetting that if currency is moving, you need to look at indices corrected for currency (that’s why ADRs fell so much more than local listings). UK indices did in fact fall further than European ones as the table above shows. We also take a look at cost of capital, which has just risen for European companies as a result of Brexit uncertainty. It’s something we spent time on at our London Technology Week valuation workshop last week.
Press articles stated that European stock markets fell more than the UK on Friday. This isn’t the case. The table above converts the share price moves of major indices into the major currencies. Looking at dollar price moves, the UK indices fell the most, and in particular the UK market focused smaller company FTSE250 index which fell -14% in dollar terms, combining the -7% index fall and the -8% weakening of sterling. It’s probably more sensible to look at the 5 day index moves, given part of what happened on Friday was a reversal of the market’s move leading up to the referendum result. It’s important to compare index moves in the same currency. This also explains why ADR share prices fell so much more than local currency for UK and European stocks.
Companies looking at how to communicate the impact of the FX move should focus on profitability first because it is imbalances between the FX exposure of your revenue compared to cost base that causes the largest changes in EPS. A UK company that sells entirely in dollars should see its profit rise much more than the currency move percentage. This explains ARM’s 6% positive move in sterling terms on Friday. It should really have risen in dollar terms too.
Let’s look at a worked example. ARM’s 2015 EBIT margin was 42%. If we assume* ARM’s revenue is 100% dollar based, but the cost base is 50% sterling, 50% dollar, then we can calculate that a +/- 10% dollar move would drive a +/-3 percentage point change in margin or a +/-17% change in sterling reported EBIT. The increase is more than the 10% currency move because in sterling (reporting) terms, revenue rose 10% but costs only rose 5%. Given most UK tech stocks fell on Friday, and that many are exporters, I suspect there is value to be found in the sector.
Stocks moved down because of the uncertainty generated by the referendum result. Investment theory would say this represents an increase in risk, and therefore discount rate, a topic we covered in our “How to value your tech business” workshop as part of London Technology Week last week. While investment theory goes on to describe discount rate in terms of WACC, we discussed thinking about it in terms of investors’ required return. If a stock is fairly valued, it will rise in nominal value each year by the “required return” of investors, a.k.a cost-of-equity. Few executives realise that this is what it means. The higher the required return, the lower your valuation, but the more rapidly your stock price subsequently rises. You therefore can’t tell investors what your cost of equity is. It is up to investors to tell you what their required return is, and this just rose for UK companies judging by the FTSE250 index move in dollar terms.
Corporate London was a sombre place Friday morning. I had meetings with two business leaders. One the British CEO of a listed technology client selling across Europe and North America,was frustrated and angry. The other, a German CEO of a private Munich based technology business, who was born in Serbia, was sadly reflective. His experience of countries breaking up (his birthplace in what was then Yugoslavia, and the Czech Slovak split) didn’t pan out particularly well.
* this cost base split assumption is an example, we are not suggesting this is correct for ARM