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Foreign currency trading concepts

Forex: The Valuation of Foreign Stocks

When investors consider investing in foreign stocks, they need methods for valuing those stocks.

First, they may attempt to use the dividend discount model, but with an adjustment to account for expected exchange rates movements.

Foreign stocks pay dividends in the currency in which they are denominated. Thus, the cash flow per period to the U.S. investors is the dividend (denominated in the foreign currency) multiplied by the value of that foreign currency in dollars. The dividend can normally be forecasted with more accuracy than the value of the foreign currency. Because of exchange rate uncertainty, the value of the foreign stock from a U.S. investor's perspective is subject to much uncertainty.

An alternative method of valuing foreign stocks is to apply price-earning ratios. The expected earnings per share of the foreign firm are multiplied by the appropriate price-earning ratio (based on the firm's risk and industry) to determine the appropriate price of the firm's stock.

While the method is easy to use, it is subject to some limitations when applied to valuing foreign stocks. The price-earnings ratio for a given industry may change continuously in some foreign markets, especially when the industry is composed of just a few firms. Thus, it is difficult to determine the proper price-earnings ratio that should be applied to a specific foreign firm.

In addition, the price-earnings ratio for any particular industry may need to be adjusted for the firm's country, since reported earnings can be influenced by the firm's accounting guidelines and tax laws. Furthermore, even if U.S. investors are comfortable with their estimate of the proper price-earnings ratio, the value derived by this method is denominated in the local foreign currency, since the estimated earnings are denominated in the local foreign currency.

Therefore, U.S. investors would still need to consider exchange rate effects.

Even if the stock is undervalued in the foreign country, it may not necessarily generate a reasonable return for U.S. investors if the foreign currency depreciates against the dollar.

A third method of valuing foreign stocks is to first focus on the country's macroeconomic conditions. Once the foreign country's economic conditions are assessed, any foreign firm within that country can be valued based on its sensitivity to the macroeconomic conditions. This method tends to allocate funds to stocks in those countries that are expected to experience strong economic conditions, and is less focused on searching for individual stocks within a country that may be undervalued.