FINANCE GURU: Here's What You Need To Know About Investing In Corrupt Companies

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Although the allegations have yet to be proven regarding Walmart’s reported involvement with Mexican bribes, the story has shed light on some shady business practices which many experts already consider to be rampant.On his Musings On Markets blog, NYU’s finance guru Aswath Damodaran discusses the existence of bribery and corruption in the global corporate world.  And finally he offers a simple methodology for incorporating these “dark” costs into valuation models.

As usual, his explanations are elegant and straightforward.

Did you ever think of considering bribes as an operating expense?  Because that’s what it is.

Countries sitting on natural resources are often led by corrupt officials.

Damodaran points to the recent case of Cobalt International Energy. According to a recent FT report, three high powered Angolan officials had hidden stakes in the company. When the report surfaced, the company instantly lost $900 million of its market cap evaporate.

Source: Damodaran

India is also notorious for corruption.

A huge telecom auction scandal in 2008 ended with the resignations and arrests of high-level politicians. Bribery among Indians is often overlooked. But bribes by foreign nationals are considered an 'abomination.'

Source: Damodaran

China has a record of shady public officials accumulating massive amounts of wealth.

Regarding the Bo Xilai scandal, Damodaran thinks the story is not about the tabloid headlines regarding wife, who has been accused of murder, or his son, who is see as a Ferrari driving playboy. Rather, Damodaran thinks the under-appreciated story has to do with politicians accumulating wealth beyond the income that comes from being a government official.

Source: Damodaran

Damodaran sees three ingredients that cause corruption to flourish.

Source: Damodaran

First, lots of bureaucracy and paperwork.

'First, for official gatekeepers to have power, you need gates: the more licenses, permissions or other official approvals you need to operate, the greater the potential for corruption.'

Source: Damodaran

Second, hegemony.

'Second, it is a lot less risky being corrupt if you have political hegemony (whether it be of the dictatorial variety or one party rule), an ineffective legal system (making it impossible to challenge biased official acts) and an apathetic or controlled media (that either cannot or will not view corruption as a good news story).'

Source: Damodaran

Third, a system in which corruption is the rule.

'Third, the odds of corruption increase if the system is designed on the premise that corruption is the rule rather than the exception.'

Source: Damodaran

Some countries are far more corrupt than others.

Here are the 10 most corrupt countries in the world according to Transparency International.

  1. Somalia
  2. North Korea
  3. Myanmar
  4. Afghanistan
  5. Uzbekistan
  6. Turkmenistan
  7. Sudan
  8. Iraq
  9. Haiti
  10. Venezuela

Source: Damodaran

So, if you're valuing a company that operates in a corrupt country there are a few ways to incorporate the cost of corruption.

Source: Damodaran

Treat bribes as operating expenses.

'From a valuation perspective, it would be easiest to deal with bribes if they were out in the open and treated as a separate line item in the expenses. So, in your operating expense breakdown, you could have a line item titled 'Bribes and payments to corrupt officials' with the expense associated with it. Perhaps, we can then assess firms on the efficiency of their bribery and treat it as a competitive advantage for companies that are exceptionally good at getting results for their money.'

Source: Damodaran

Treat corruption as an implicit (and unreported) tax.

'In the more likely scenario, where corruption exists but is not explicitly reported, it may make sense to consider the expenses associated with it as an implicit tax levied by the government. The fact that this tax revenue goes to the government officials and not to the taxpayers is deplorable, but that makes little difference to the company paying it.'

Source: Damodaran

'When corruption occurs at the highest levels, you can argue that as a private business owner, you have 'corrupt government officials' as partners who provide no capital but get a share of the income. Consequently, you have to generate a higher return on your capital invested to cover the cash outflows to your implicit partners.'

Source: Damodaran

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