How does purchasing power parity affect international equity valuation, and should I adjust DCF models for PPP?

International valuation with currency considerations is a classic Level II topic that integrates equity valuation with economics. The key is understanding when PPP is relevant and which approach to use.

Two Approaches to International DCF:

Approach 1: Foreign Currency DCF (then convert)

• Project cash flows in the local currency (euros)
• Discount at the local currency cost of capital
• Convert the resulting intrinsic value to domestic currency (USD) at the spot rate

Approach 2: Domestic Currency DCF

• Convert each year's foreign currency cash flows to domestic currency using forward rates or PPP-implied rates
• Discount at the domestic currency cost of capital

Where PPP Comes In: PPP predicts that the exchange rate adjusts to equalize purchasing power across countries. The relative PPP formula gives us expected future exchange rates:

E(S_{t}) = S_0 x [(1 + inflation_domestic) / (1 + inflation_foreign)]^t

This is theoretically equivalent to using forward rates (via covered interest rate parity) in a well-functioning market.

Worked Example: You're valuing Stellaris Aerospace (headquartered in Frankfurt) from a USD perspective.

Item	Value
Year 1 FCFF (EUR)	EUR 180M
Year 2 FCFF (EUR)	EUR 210M
Terminal value (EUR)	EUR 3,500M
EUR WACC	8.5%
USD WACC	9.2%
Spot rate	$1.12/EUR
US inflation	2.8%
Eurozone inflation	2.0%

Using PPP to forecast exchange rates: Year 1: $1.12 x (1.028/1.020) =$1.129/EUR Year 2: $1.12 x (1.028/1.020)^2 =$1.138/EUR

Approach 1 (EUR DCF then convert): EV_EUR = 180/1.085 + 210/1.085^2 + 3500/1.085^2 = EUR 3,316M EV_USD = EUR 3,316M x $1.12 = **$3,714M**

Approach 2 (Convert then USD DCF): Year 1 FCFF_USD = EUR 180M x $1.129 =$203M Year 2 FCFF_USD = EUR 210M x $1.138 =$239M Terminal_USD = EUR 3,500M x $1.138 =$3,983M EV_USD = 203/1.092 + 239/1.092^2 + 3983/1.092^2 = $3,720M

The two approaches give approximately the same answer (small differences due to rounding), which is a consistency check.

Practical Considerations:

• PPP holds better over long horizons (5+ years) than short-term
• For 1-2 year forecasts, forward rates may be more appropriate
• Emerging market currencies often deviate significantly from PPP due to capital controls, trade barriers

Exam Tip: Both approaches should give the same value if applied consistently. The exam often tests whether you can correctly apply PPP-implied rates and identify which discount rate matches which currency's cash flows.

Explore international equity valuation in our CFA Level II course.